ECON 209 – Macroeconomics

Start-Up

What is ‘Macroeconomics’?

Microeconomics (Econ 208) focuses on individual economic units – individual markets,

individual consumers & firms.

Macroeconomics focuses on the overall economy.

 National income
 Economic growth
 Employment/unemployment
 Prices & inflation
 Exchange rates
 Trade
 Monetary and fiscal policy

Basic theory of how the economy works (or fails to work)

 Then use theory to examine things of concern to politicians, to the press, and to the
general public

Introduction to Macroeconomic Issues

Chapter 19: What Macroeconomics Is All About

The Circular Flow of Income and Expenditure

The Circular Flow of Expenditure and Income

19.1 – Key Macroeconomic Variables

Output and Income

 Output generates income.
 Total $ value of domestically produced G & S – nominal national income (nom. GDP)
 To find annual ∆ in Q of prodn between years must adjust for inflation (i.e., measure in
constant dollars)
 Value current output at some base-period prices – real national income (real GDP)

Unless otherwise specified, text refers to real GDP

 Real econ growth means real GDP increases.

 Real per capita economic growth means real GDP per person increases
 But it’s an average – some individuals may actually be worse off

Growth and Fluctuations in Real GDP, 1965-2017

Real GDP fluctuates around a rising trend:
 The rend shows long-run economic growth
 The short-run fluctuations show the business cycles

Recession is period of negative economic growth (commonly defined as 2 consecutive quarters)

The Terminology of Business Cycles

Potential output (Y*): Real GDP if all resources employed at normal intensity of use
 Often called full-employment output

The upward trend in Y* is caused by growth in the economy’s productive capacity (labour force,
capital stock, technological change)

Output gap is the difference between potential & actual output and actual output

Output Gap = Y – Y*
Y < Y* a recessionary gap
Y > Y*, an inflationary gap
Potential GDP and the Output Gap, 1985-2017

Employment, Unemployment, and the Labour Force

Employment (E): the number of workers (15+) who hold jobs

Unemployment (U): the number (15+) not employed but actively looking for a job

Labour force (LF): E + U

Unemployment rate: U as a % of LF – U/(E+U)*100

Stats Can’s monthly rate is seasonally adjusted – i.e., compensated for normal (average)
changes over the years

Unemployment rate = (number of people unemployed/number of people in the labour

force)*100

Note: the # of Ued can increase even if U rate unchanged

Even when Y = Y*, some unemployment exists:

 Frictional unemployment (natural turnover)
 Structural unemployment (mismatch between jobs and workers)

When Y < Y*, there is also cyclical unemployment

 Long-term trend: employment has grown roughly in line with the growth in the labour
force
 Been large short-term fluctuations in U rate from 3.4% in 1966 to 12% in 1982

Why Does Unemployment Matter?

Some U is desirable: e.g., frictional reflects time needed for workers & firms to “find” each
other – so good matches are made

Some U associated with human hardship: e.g., structural is longer-term U (usually long-term)
caused by mismatch between skills of Ued & those required to fill vacancies – not in demand
by firms

Labour Force, Employment, and Unemployment, 1960-2018

Productivity

Productivity: output per unit of input

 Usually as (real) GDP per worker
 Or (real) GDP per hour of work

Increases in prody, probably single largest cause of LR increases Standard of Living

 New & better technology
 Improvement in skills (e.g. education)

Note: A 3% increase in real GDP with a 4% increase in population gives reduction in the average
S of L.

Canadian Labour Productivity, 1976-2017

Ave annual real growth: GDP/worker = 0.98%, GDP/hour = 1.1%

Inflation and Price Level

P level: average (?) level of all prices expressed as an index number

Inflation: % increase in price level
Consumer price index (CPI): index of the average prices of G & S bought by average households

CPI is based on the price (i.e., cost) of a typical “consumption basket” relative to its base year
price

Beyond the text: Calculating Consumer Price Index (CPI)

How the CPI is Constructed

Assume there are only 2 goods, a and b. the P and Q are prices and quantities, and the number
1 indicates the base year. The CPI in the base year is:

[(Pa1 x Qa1 + Pb1 x Qb1)/(Pa1 x Qa1 + Pb1 x Qb1)] x 100 = 100

Putting hypothetical numbers on this:

[($10 x 100a + $5 x 50b)/($10 x 100a + $5 x 50b)] x 100 = (1250/1250) x 100 = 100

In year 2, Pa rise from $10 50 $11 (a 10% rise), Pb rises from $5 to $6 (a 20% rise). The P index
for year 2 is:

[($11 x 100a + $6 x 50b)/($10 x 100a + $5 x 50b)] x 100 = (1400/1250) x 100 = 112

Annual % inflation rate = (change in index/index from 1 year ago) x 100 = (12/100)x100 = 12%

12% is a weighted average – rise in Ps of G & S weighted by the relative importance of each
good in the average consumer’s spending.

In base year, 4/5 of income spent on Good a. Only 1/5 on Good b.

4/5 of 10% + 1/5 of 20% = 8 + 4 = 12

Deficiencies of the CPI over long periods

 Changes in the quality of output
 Needs periodic updating of the base year
o New products (i.e., goods in the basket)
o Changes in spending patterns (i.e., the weights)
Note that the calculated inflation rate using the CPI is for the goods consumed by the ‘average’
household.
The actual inflation rate for (e.g.) low-income households may be quite different than for high-
income households.

Importance of Inflation

The purchasing power of money is negatively related to the price level. So inflation:
 Hurts people on fixed incomes (Rules of 72)
 Reduces real value of things with a fixed price
 Creates expectations of further inflation, which affects other behaviour (e.g., US house
prices & savings rate)

The Price Level and the Inflation Rate, 1960-2018

Upward trend in P level over the past half-century.

Sine 1960, inflation rate varied from almost 0 to > 12%

Interest Rates

The interest rate is the price of “credit” flow of credit crucial to firms and households in a
modern economy

Nominal interest rate: expressed in money terms

Real interest rate: expressed in terms of purchasing power

Real interest rate = nominal rate minus inflation rate

The effects of inflation on borrowers & lenders depends on the real interest rate. In real terms,
unanticipated inflation
 Hurts the lender
 Benefits the borrower

Real and Nominal Interest Rates, 1965-2018

The International Economy

Foreign exchange: foreign currencies (or claims on foreign currencies)

Exchange rate: # of Canadian $ to buy/sell unit of foreign currency.
June 2015: $1 buy 0.72 euros – or 1 euro cost 1.38 dollars

Depreciation of the Canadian $ - worth less on the foreign exchange market

 A rise in the exchange rate
 Takes more C$ to buy unit of foreign currency
Domestic P of Canada’s imports rises, Foreign price of Canada’s exports falls.

Canadian-US Dollar Exchange Rate, 1970-2018

The balance of payments accounts record all payments made in international transactions –
goods, services, and assets
 Trade balance (net exports), (current account)
 Capital account balance

For Canada, exports and imports are both very large – roughly 35% of GDP – but the balance of
trade is usually small.
Balance of payments always sums to zero.
If someone sells a Canadian dollar, someone else must buy it.

Canadian Imports, Exports, and Net Exports, 1970-2017

19.2 – Growth Versus Fluctuations

Long-term economic growth

Long-term growth – important for society’s living standards

How much can government actions affect the economy’s LR growth rate? Much debate

Short-term fluctuations

Short-term fluctuations – business cycle

Different views on effectiveness of monetary and fiscal policy to influencing these fluctuations.
Some economists argue governments should not attempt “fine-tuning” despite the “power” of
policy to affect the economy

Beyond the text: The importance of expectations

Are Recessions & Booms Self-Fulfilling Prophecies?

Step 1: General pessimism about future. Consumers expect ave. incomes to stop growing &
firms expect sales to stop growing. (Note: not have to fall)

Step 2: Firms cut investment spending: less intermediate capital goods are produced. Some
workers are laid off.

Step 3: Laid-off workers buy less consumer goods & services. And increased fear of lay-off cause
other households to increase saving and reduce spending.

Step 4: Firms reduce production of final consumer goods. The cycle continues into recession.

Result: Expectations seem to have been correct. But only correct because of how economy
reacted to expectations.

What lies ahead?

To organize our thinking about macroeconomics, we must develop some tools. These will
include:
 Discussing measurement of national income
 Building a simple model of the economy
 Modifying the model to make it more realistic
 Using our model to analyze some pertinent economic issues

Chapter 20: The Measurement of National Income

20.1 – National Output and Value added

Production stages:
 Intermediate products
 Final products (G & S)
GDP = value of final G & S produced in the domestic economy
 Includes additions to inventory (produced that year)
 Includes exports to intermediate goods – ‘final’ sales domestically
 Excludes imported final goods – not domestic production

Problem: distinguishing between final goods and intermediate goods (e.g., what is milk?)
Double counting avoided by value added
Each firm’s value added:
= revenues – cost of intermediate goods
= incomes to factors of production (at the firm)
Total value added gives Gross Domestic Product (GDP)

20.2 – National Income Accounting: The Basics

Three methods for measuring national income (output):

 Total value added from domestic production
 Total expenditures on domestic output
 Total income generated by domestic production
Because of the circular flow of income, these three measures yield the same total – GDP

GDP from the Expenditure Side

Sum of expenditures needed to buy total year’s output

4 broad categories:
 Consumption (C)
 Investment (I)
 Government purchases (G)
 Net exports (X-M)
Ca is actual spending on final G&S consumed in given period
 Using final goods only avoids double counting
 Home ownership valued at imputed rental value
Ia = actual spending on production not for present consumption, including:
 Change in inventories (at market value, not at cost)
 Plant and equipment (Business fixed investment, or fixed investment)
 Residential investment (new housing construction – treated as investment, not as
current consumption)

Note: Gross Investment is of two types

 Replacement investment – maintains level of capital stock, (including depreciation)
 Net investment (adds to capital stock)
Also nets out depreciation of gross investment

Actual government purchases (Ga)

 Excludes transfer payments
 Valued at cost (‘market value’ of PEI bridge? The army?)

Note: Even if total output unchanged, moving some prodn from government to private sector
could increase GDP! Why?
*Because now valued at market value instead of at cost*

Actual net exports (NXa) = (Xa – IMa)

Exports added: produced in Canada (not consumed)
Imports subtracted: not produced here
(Uses value when the imported goods enter Canada)

Note: Visitors’ spending in Canada is export

Canadians’ spending abroad is import
Sum the categories and get actual GDP:
GDP = Ca + Ia + Ga + NXa

GDP from the Expenditure Side, 2017

Measuring GDP from the Income Side
GDP from the Income Side

Factor incomes + non-factor payments (‘claims’ on output value)

a. Factor incomes:
 Labour: wages & salaries (before deductions)
 Capital: rent, interest, and profits
Together, these make the nest domestic income

Note: ‘Interest’ excludes interest on government bonds – a transfer payment

b. Non-factor payments:
 Indirect maxes minus subsidies (gives true market values)
o Example: firm revenues = $10 000 of which $2000 is a government subsidy. So
market value = $8000
 Depreciation (of existing K)
o Physical capital depreciates as it helps produce current output. So even though
the K was produced in previous years, is creating income/output in current year
o Measured by Capital Consumption Allowance in taxes

GDP from the income side is therefore equal to:

GDP = Net domestic income + indirect taxes (less subsidies) + Depreciation
Example: Additions to inventory valued at market prices (not cost) even though not yet sold
Arbitrary decisions can affect measured level of GDP, but minimal relevance for changes in GDP
GDP from the Income Side, 2017

20.3 – National Income Accounting: Some Further Issues

Real and Nominal GDP

This year’s output valued at current prices is called nominal GDP.
This year’s output valued at base-period prices is called real GDP.

The GDP Deflator

If nominal and real change by different amounts between years, the different must be caused
by P changes.
So, get another measure of inflation from the GDP deflator (next slide)

GDP from the Income Side

The GDP deflator is an index number derived by dividing nominal GDP by real GDP
Change in Deflator measures change in P of all items in GDP

GDP deflator = Nominal GDP/Real GDP x 100

GDP Deflator Versus the CPI

Changes in GDP deflator not necessarily same as changes in CPI (Consumer Price Index)
Measuring different things:
 Change in CPI reflects the change in the average price of goods consumed in Canada
(including imports)
  Change in GDP deflator reflects the change in the average price of goods produced in
Canada (including exports)

Omissions from GDP

Econ activity outside of regular, legal markets:
 Illegal activities
 Leisure
 Underground economy (estimates of Canadian underground economy vary from 2% to
15% of GDP. Italy estimated at 25%)
 Home production (DIY, homemaker services and volunteer activities outside the home)
 Economic ‘bads’ (Note: spending is to clean up pollution increases measured GDP – but
in reality are only compensating for an economic ‘bad’)

Do the Omissions Matter?

The way GDP is measured is useful because:
1. Would be difficult to correct for the major omissions
2. The level of GDP may be inaccurate but the change in GDP is a good indication of the
changes in economic activity
3. For policy decisions to control inflation need to know money used to make & buy
Canadian output
Including non-market activities could distort the figures and likely lead to policy errors

GDP and Living Standards

GDP not a complete measure to use for living standards
 G&S only part of what most people see as their S of L
 But changes in real per capita income are good indicator of changes average material
living standards

No ‘right’ base year – but % change in GDP between years are same regardless of which base
year chose
Example: would the ‘importance’ of a barrel of albert’s oil be the same at 1995 prices and 2015
prices?

Note of Caution: Non-market activities and econ bads can be a problem when comparing
different countries
Example: Non-market activities more prevalent in rural settings?
Econ bads are more prevalent in urban settings?

GDP and Living Standards

“Well-being” is a broader concept than material living standards:
 GDP is not a complete measure of economic well-being
 But income is a very important part of it & GDP is good measure of income
Chapter 21: The Simplest Short-Run Macro Model

21.1 – Desired Aggregate Expenditure

The national accounts divide actual GDP into its components:

GDP = Ca, Ia, Ga, and NXa

Total desired expenditure is divided into the same categories:

 Desired consumption, C
 Desired investment, I
 Desired government purchases, G
 Desired net exports, NX
The sum is called desired aggregate expenditure:
AE = C + I + G + NX

Two types of expenditures:

 Autonomous expenditures do not depend on the level of national income
 Induced expenditures do not depend on the level of national income

The first step

Simplest economy – no government or trade (i.e., a ‘closed’ economy, and no government)

AE = C + I
Assume Ps constant – no inflation
Investment is autonomous (for the moment)
Highly unrealistic – but introduction to many of the interlinkages & ‘tools’ needed for more
realistic economy

What does ‘desired’ really mean?

‘Desired’ expenditure is not what consumers and firms would buy if they had no constraints on
their spending.
It is much more realistic than that.
It is what consumers and firms would like to purchase given their real-world constraints of
income and market prices.

Desired Consumption Expenditure

Disposable income used for:
 Consumption (C), or
 Saving (S)
In our simplest theory, C determined by current disp. Income (Y D)
In more advanced theories, individuals are forward looking – C depends also on “lifetime”
income.
C decisions made using both current Y & expected future Y.
Expected future Y has a ‘smoothing’ effect on C:
 Anticipated changes in Y already influence ‘lifetime’ C decisions
 Cause less change in current C than with our simplified Keynesian C function
 Even unanticipated changes in current Y affect C if change expectations of future Y
We use simplified Keynesian function (although we will not ignore expectations)

Consumption and Disposable Income in Canada, 1981

Simple C function:

The marginal propensity to consume (MPC) gives change in desired C as Y D changes

 MPC = ∆C/∆YD
The MPC is slope of C function
In the diagram, is the MPC same at any level of income

The average propensity to consume (APC) is total C as proportion of total Y D

APC = C/YD
In our diagram, the APC falls as the level of income rises

So, going back to the simple consumption function we see:

The Consumption and Saving Functions

Since all of disposable income is either consumed or saved, we have
 APC + APS = 1
 MPC + MPS = 1
Is our simple theory of the consumption function supported by empirical evidence? For some
Canadian data on aggregate consumption and disposable income, look for The Consumption
Function in Canada in the Additional Topics section of this book’s MyEconLab.

Shifts in the Consumption Function?

In C function shifts up, S function must shift down.
Shifts may be:
- Parallel: no change in MPC (& MPS)
- Change in slope: changes both the MPC and APC (& MPS & APS)
What causes a shift in C & S functions?
 ∆ wealth: more wealth shifts C function up and S function down. Need to save less for
the future (e.g., retirement or children’s education), so can increase desired spending on
current C
 ∆ interest rate: fall in (real) interest rate cuts cost of borrowing, so cuts cost of higher-
priced durable goods and it also reduces the rate of return on savings
 ∆ expectations: increased pessimism about the future earning & employment prospects
increases desired current S and reduces desired current C

Desired Investment Expenditure

Investment expenditure is the most volatile component of GDP:
 Changes in expenditure strongly associated with short-run GDP fluctuations

Three important determinants of aggregate investment expenditure:

 The real interest rate
 Changes in the level of sales
 Business confidence/expectations
Look at these individually

The Real Interest Rate

The real interest rate is the opportunity cost of:
 Investment in new plant equipment
 Investment in inventories (small $ value, but important because volatile)
  Investment in residential construction (also volatile – e.g., ∆ in (real) r of I have big effect
on D for housing via the cost mortgages)
All three – related to the r of I (ceteris paribus)

Changes in Sales
Higher is level of production & sales, larger is desired inventory level:
 Changes in sales can cause temporary changes in investment in inventories (change
stops when get to new desired level)

Business Confidence
When business confidence improves, firms want to invest now in response to incentive for
higher future profits.
Business confidence and consumer confidence may feed off of one another.

The Aggregate Expenditure Function

The AE function:
 Agg exp function relates desired AE & actual national income (given the r of I,
expectations etc.)
Without government & international trade, desired AE is:
AE = C + I
Example:
The C function is: C = 30 + (0.8)Y
The I function is: I = 75
The AE function is: AE = C + I = 30 + (0.8)Y + 75
AE = 105 + (0.8)Y = A + zY
Slope of AE function is the marginal propensity to spend (out of National Income):
 In this simple model, it is just MPC

21.2 – Equilibrium National Income

If desired aggregate expenditure exceeds actual output:

 What is happening to inventories?
 There is pressure for output to rise
If desired aggregate expenditure is less than actual output:
 What is happening to inventories?
 There is pressure for output to fall

Equilibrium National Income

The economy is in equilibrium when desired aggregate expenditure equal actual national
income.

The equilibrium condition is:

Y = AE(Y)
That is, desired AE out of national income [AE(Y)] equals actual national income [Y].

See equilibrium using injections = withdrawals

In equilibrium:
Y = AE = C + I But: C + Y – S
Y=Y–S+I Y–Y+S=I
S=I

In this simple model, you recall, we kept the price level constant
This would mean that as the economy wishes to consume more, it will be provided (i.e.,
produced) without any change in price.
That is, none of our increased demand for output will be ‘squeezed out’ by higher prices.
So, production (aggregate supply of output) in this highly simplified economy is demand
determined.

21.3 – Changes in Equilibrium National Income

Shifts of the AE Function

Two types of shifts of AE function:
1. The AE function can shift parallel to itself
2. The slope of the AE function can change

The Multiplier
The multiplier measures ∆ in equilibrium Y resulting from ∆ in autonomous expenditure. In this
simplest of macro models, in equilibrium:

Y = AE = C + I = a + bY + I = (a + I) + bY
Y = A + bY (1 – b)Y = A Y = A/(1 – b)
∆Y/∆A = 1/(1-b)
The multiplier exceeds one
[b < 1 so 1/(1-b) > 1]

The Simple Multiplier Illustrated

z is the marginal propensity to spend out of national income
∆Y/∆A = 1/(1 – z)
In our simple model z = b
∆ A is (an autonomous) change in desired AE

The Size of the Simple Multiplier

(i) Flat AE, multiplier = 1

(ii) Intermediate case

 (iii) Steep AE, multiplier large

Larger is z, steeper is the AE curve & larger is the simple multiplier

Example:
Finding the Simple Multiplier
AE = C + I = a + bY + I
AE = a + I + bY
= A + bY

In the simplest model, z =b

Y = A + zY
(1 – z)Y = A
Y = 1/(1-z)
Y = 1/(1 – z)A
∆Y = 1/(1 – z)∆A

AE = 100 + 0.8Y + 500

AE = 100 + 500 +0.8Y
= 600 + 0.8Y

In equilibrium, AE = Y
Y = 600 +0.8Y
(1 – 0.8)Y = 600
Y = 600/0.2
Y = 1/0.2 600 = 5(600) = 3000
∆Y/∆A = 1/(1 – z) = 1/0.2 = 5

Chapter 22: Adding Government and Trade to the Simple Macro Model

22.1 – Introducing Government

Government Purchases
Government purchases of G & S (G) are part of desired AE
 Not including transfer payments
 All levels of government – federal, provincial, territorial municipal

Net Tax Revenues

Net taxes (T) are total tax revenues net of transfer payments

Simple model – G is autonomous, T is induced

Assume the net tax function is: T = tY

Where t is the net tax rate (assumed autonomous & average = marginal)
T enters the AE finction indirectly via the consumption function:
C = a + bYD = a + b(Y-T)

The Budget Balance

The budget balance is the different between G and T*
 If G < T: a budget surplus (‘public saving’ > 0)
 If G > T: a budget deficit (‘public saving’ < 0)

22.2 – Introducing Foreign Trade

Net Exports
Two assumptions:
  Canada’s exports are autonomous with respect to Canadian GDP
 Canada’s imports rise as Canadian GDP rises
o IM = mY
o Where m is the marginal propensity to import
Thus, net exports are given by: NX = X – mY

Ceteris paribus, changes in domestic GDP lead to changes in net exports:

 As Y rises, NX falls (as imports rise)
 As Y falls, NX rises (as imports fall)
The relationship between Y and NX is shown by the net export function

The NX function is drawn holding constant:

 Foreign GDP
 Domestic and foreign prices
 The exchange rate

Imports are induced by national income

Exports are autonomous with respect to domestic GDP
They do depend on:
 Foreign income
 Domestic and foreign prices
 Exchange rate
 Tastes

Shifts in the Net Export Function

 An increase in foreign income leads to more foreign demand for Canadian goods:
o Increases X and shifts NX function upward
 A rise in Canadian prices (foreign prices constant) increases relative Ps of Canadian G&S:
o Decreases X (shifts NX down)
o And the IM function steeper as Canadians switch toward foreign goods
o NX function shifts down and gets steeper

Rise in Canadian prices relative to foreign prices

This could be caused by:
 Canada’s inflation rate greater than foreign rate
 ∆ exchange rate

Example: a fall in our exchange rate (i.e., an increase in the value the C$)
 Increase the foreign price of our exports, and (so X falls)
 Reduces the C$ price of our imports (so IM rise)

22.3 – Equilibrium National Income

Desired Consumption and National Income
If T = (0.1) Y, then YD = (0.9) Y
 MPC out of national income (0.72)
 < MPC out of disposable income (0.8)
C = 30 + (0.8)YD
C = 30 + (0.8)(0.9)Y
C = 30 + (0.72)Y

C = a + b(Y – tY) = a + b(1 – t)Y

The AE Function
Expand the AE function:
AE = C + I + G + NX
AE = a + b(1 – t)Y + I + G + X – mY
AE = [a + I + g + X] + b(1 – t)Y – mY
AE = A + [b(1 – t) – m)]Y = A + zY

Slope of the AE function is the marginal propensity to spend out of national income – we call
this z
In this model, we get:
Z = MPC(1 -t) – m z = b(1 – t) – m
Clearly, t > o and m > 0 lead to a lower value of z

Equilibrium National Income

Output still assumed demand determined:
 Equilibrium condition is Y = AE
Whenever AE is not equal to Y:
 There are unintended changes in inventories, so
 Firms have an incentive to change production, and
 Output moves toward equilibrium at Y = AE

Another way to show the equilibrium condition

We have seen: S + T + IM = I + G + X
Rearrange and get:
Desired national saving = Desired national asset formation
S + (T – G) = I + (X – IM)
The GDP where these are equal is the GDP where Y = AE

22.4 – Changes in Equilibrium National Income

The Multiplier with Taxes and Imports

The marginal tax rate (t) and the marginal propensity to import (m) reduce z (the marginal
propensity to spend out of national income)
AE = A + [b(1 – t) – m]Y = A + zY
Z = b(1 – t) – m

The smaller z also reduces the simple multiplier 1/(1-z)

 The smaller z increases (1-z), which in turn reduces 1/(1-z)

Fiscal Policy
Refers to government spending and tax policies (which influence the budget deficit or surplus)
Any policy to keep Y at or near Y* is called stabilization policy
 Y < Y* suggests increase G and/or reduce T
 Y > Y* suggests reduce G and/or increase T
Often is clear direction for fiscal policy, but its less clear how much adjustment is needed

AE = A + [b(1-t) – m)]Y = A + zY z = b(1 – t) – m

The next two slides show examples policies using the two tools of fiscal policy – government
spending and government taxation
 First, contractionary fiscal policy by reducing G (a negative ∆G). this is a change in A,
leaving Z unchanged
 Second, expansionary fiscal policy using a reduction in the tax rate (t). the (autonomous)
change in the tax rate changes the (induced) tax revenues (T)
So Z changes but A remains unchanged

AE = A = [b(1-t) – m)]Y = A + zY
Contractionary: reduce G (∆G < 0)
In AE = A + zY, A falls. Equilibrium Y falls by ∆Y
∆Y = ∆G x simple multiplier
∆Y = [1/(1-z)]

For example, suppose z – 0.25  multiplier = 1.30

∆G = -$100 million  ∆Y = - $130 million

AE = A + [b(1-t)-m]Y = A + zY z = b(1-t) – m

Expansionary: reduce the tax rate t

Z is a slope of AE. Reducing t increases z (i.e., makes AE steeper)
The higher z has increased the equilibrium Y from Y0 to Y1.

The bigger z has

 Increased the multiplier (1/1-z) which, when applied to the unchanged A increases Y by
∆Y = ∆ [1/(1-z)]A
The balanced-budget multiplier
This occurs when the there is an equal increase in G and T, so the budget deficit or surplus
doesn’t change
In principle, this can have a mild expansionary effect
How can this be?

There’s an equal increase in government injections and withdrawals, but for the economy the
increase in injections exceeds the increase in withdrawals
 The increase in T reduces YD
 The fall in YD reduces S
 The net change in withdrawal = increase T minus decrease S
Although increase G = increase T, increase G > increase T+S so increase injection > increase
withdrawals
The net injection means consumption (C = f(YD) doesn’t fall by the full rise in T
Caveat: raising taxes can’t go on and on, continually stimulating output higher and higher taxes
would eventually cause a big enough reduction incentive to work that GDP would fall

22.5 – Demand-determined output

Our simple macro model (chapters 21 and 22) is based on three central concepts:
 Equilibrium national income
 The simple multiplier
 Demand-determined output
Demand-determined output is implicit in the assumption that firms will produce all that is
demanded at the current (i.e., constant) price level
Both simple multiplier and demand-determined output are closely connected to the
assumption of a constant price level, determined exogenously
The next chapter brings supply side of the economy because of the interactions between
aggregate demand and aggregate supply. The price level and inflation to be determined
endogenously.

Chapter 23: Real GDP and the Price Level in the Short Run

Part A: Aggregate Demand

23.1 – The Demand Side of the Economy

Exogenous Changes in the Price Level

Changes the AE curve because of effects on:
 Real value of wealth
 Net exports

Changes in real value of wealth

Increase P level  decrease real value (purchasing power) of private sector wealth held in the
form of money
Increase P level causes decrease real value of private sector wealth, which
 Reduces desired C (at each level of Y), which
 Causes decrease shift in AE curve
Reverse for decrease P level (via increase real wealth)

Note: Why only private sector and only held as money?

 Government ‘bonds’ are part of the wealth held by the private sector, as corporate
bonds… but
 ∆P has equal and opposite effects on real wealth of bondholders & bond issuers – so no
∆ in their aggregate wealth of these 2 groups (unless bonds are held by foreigners)

Effect on net exports

∆ domestic P level  ∆ relative P pr domestic vs foreign G & S
Increase P level  decrease X & increase IM (at each level of Y), which
 Shifts NX function downward, causing
o Further downward shift in AE curve
o Reverse it for a fall in P

Effect on Equilibrium GDP

Increase P  decrease desired aggregate expenditure
 AE shifts down
 Equilibrium Y falls
Process:
 Increase P  ∆AE via decrease C & decrease NX
 ∆AE is ‘multiplied up’ to an even bigger ∆Y

The Aggregate Demand Curve

 The aggregate demand (AD) curve relates equilibrium real GDP to P level
 At each P, the AD curve shows real GDP at which desired aggregate expenditure (AE)
equal actual GDP.
 ∆AE curve caused by ∆P level is movement along AD curve
 ∆AE curve caused by changes in anything else is a shift of the AD curve (called an AD
‘shock’)
Now increase P:
 First P0 to P1
 Then P1 to P2
AE curve shifts, which creates the movement along the AD curve
Why along? Because the initial cause was a change in price
Points OFF the AD curve are combinations of P & Y at which desired AE does NOT equal actual
GDP

Why is the AD curve negatively sloped?

 From your Micro you may reason that the AD curve is the horizontal summation of the D
curves for all individual G & S?
 Since the individual D curves have negative slopes, then the horizontal sum of them
must also have negative slope – WRONG
 That reasoning is a “fallacy of composition” – i.e., it assumes that what is correct for the
parts must be correct for the whole – but in this case it isn’t, WHY NOT?
 The demand curve for an individual good or service is negatively sloped because a
change in its price (cet. Par.) changes its opportunity cost – i.e., it changes relative prices
 But along the aggregate D curve, whole P level (as in the CPI) is changing – relative Ps
need not change*
So why does the AD slope down?
Central reason (for now) is:
 ∆P level on changes wealth because it
 Changes the purchasing power of money holdings*
 Which changes AD for the economy’s good and services
*Except between domestic & foreign goods
*the money component of ‘wealth’

What causes shifts in the AD curve?

 Any ‘shock’ that increases equilibrium GDP at a given price level shifts AD curve to the
right
 The horizontal shift of the AD curve is: 1/(1-z)∆A
 For given ∆A, bigger is 1/(1-z) then bigger is ∆AD

Issue:
 How much of the shift in AD gets ‘translated’ into
o Increases in output (Y)
o Increase in price level (P)
 Answers depends on slope of aggregate supply curve (AS)
  So, our next step is to examine the supply side of the economy
 Having done that, well put the demand & supply sides together

Part B: The Economy’s Aggregate Supply, and putting AD & AS together

23.2 – The Supply Side of the Economy

The Aggregate Supply Curve

The AS curve relates P level to Q of output that firms would like to produce and sell
The AS curve is drawn for a given:
 Level of technology
 Set of factor prices
As unit costs rise with output (Not caused by change in factor Ps), firms will produce more
output only if product Ps rise:
 AS curve is upward sloping
If factor prices are unchanged along any given AS curve, why does slope of the AS curve
increase (gets steeper) as output rises?
 When output is low, firms typically have excess capacity
o Costs do not rise quickly
 When output is nearer Y*, begin to run out of excess capacity & costs rise as output
rises
o Firms need higher prices

Shifts in Aggregate Supply Curve

Aggregate Supply Shocks
Anything that increases firms’ cost causes the AS curve to shift up (to left) – a reduction in AS:
 Factor prices
 Technology
Reverse for new technology that increases productivity, so reducing costs
23.3 – Macroeconomic Equilibrium

Only at intersection of AD & AS

 Curves is D behaviour
 Consistent with S behaviour
 E0 is the macroeconomic equilibrium

Changes in Macroeconomic Equilibrium

Demand shocks can either be expansionary or contractionary
 Direction of AD shift
Supply shocks can either be expansionary or contractionary
 Direction of the AS shift
In both cases, “expansionary” or “contractionary” refers to the effect on equilibrium output

Aggregate Demand Shocks

Demand shocks cause P and Y to change in the same direction
Possible causes:
 ∆G > 0
 ∆I > 0
 ∆X > 0
 ∆C > 0
The Multiplier when the Price Level Varies
The Mechanics of an AD Shift
 If D shock causes increase shift of AE, then resulting increase P level shifts it part-way
back down
 Because of increase sloping AS curve, final multiplier smaller than the simple multiplier

(i) Aggregate expenditure

 (ii) Aggregate demand

The Effects of Increases in Aggregate Demand

The effect of any given shift of the AD curve will depend on the slope of the AS curve
For a given shift of AD curve, then the steeper the AS curve:
 The greater the price effect
 And the smaller the output effect

Step-By-Step Summary of Effects of AD Shock

With upward-sloping AS, and using increase G as example
Step 1: AE shifts up by ∆G, & AD shifts right by 1/(1-z)∆G
Step 2: AD > AS causes higher Y – but at higher P
Step 3: Rise in P shifts AE part-way back down as reduces:
 Desired C via wealth effect
 NX via relative P changes
Step 4: This ∆AE via ∆P reduces AD by movement along AD cruve
Step 5: As P rises, the gap between AD & AS gets less as:
 AS rises along the AS curve
 AD falls along the AD curve
 Until new equilibrium at new AD = AS again
End result:
 Equilibrium P and Y moved in same direction
 Final multiplier less than the simple multiplier {1/(1-z)}

Aggregate Supply Shocks

P & Y change in opposite directions
Reduction in AS causes AD > AS
 Increases P reduces AE
 Move along ‘old’ AD
 Move along ‘new’ AS
 New equilibrium at higher P & lower Y
Possible causes:
 ∆ price of inputs
 ∆ wages
 ∆ technology

A Word of Warning
Many economic events (especially changes in the world prices of raw materials) cause both AD
and AS shocks – complex shocks
The overall effect on the economy depends on the relative importance of the two separate
effects

Example: Recession in ‘Asian Tiger’ countries in 1997

 Big users of raw materials – an important Canadian export
 Their recession caused decrease Dworld for raw materials, causing decrease Pworld a
negative AD shock for Canada
  On its own, this d-side shock would decrease P and decrease Y
 But decrease Pworld reduced production costs of other goods in Canada. A positive AS
shock
 On its own, this S-side shock would decrease P and increase Y
 But decrease Pworld reduced production costs of other goods in Canada. A positive AS
shock
 On its own, this S-side shock would decrease P and increase Y
 So, both shocks would decrease P, but opposing effects on Y
 Actual result for Canada: negative AD shock > positive AS shock, so net effect was fall in
GDP

Chapter 24: From Short Run to Long Run- the Adjustment of Factor Prices

Part A: From Output Gaps to Y*

24.1 - Three Macroeconomic States

The Short Run

 Factor prices are assumed to be constant
 Technology and factor supplies are assumed to be constant
The Adjustment of Factor Prices
 Factor prices are flexible
 Technology and factor supplies are constant
The Long Run
 Factor prices have fully adjusted
 Technology and factor supplies are changing

24.2 – The Adjustment Process

Potential Output and the Output Gap

Factor Prices and the Output Gap

When Y > Y*, the demand for labour (and other factor services) is relatively high
 An inflationary output gap
During an inflationary output gap there are high profits for firms and unusually large demand
for labour
 Wages and unit costs tend to rise
When Y < Y*, the demand for labour (and other factor services) is relatively low
 Recessionary output gap
During a recessionary gap there are low profits for firms and low demand for labour (AS shifts
down, economy moves down along AD curve)
 Wages and unit costs tend to fall*
*assuming no productivity growth

Adjustment asymmetry:
 Inflationary output gaps typically raise wages rapidly
 Recessionary output gaps often reduce wages only slowly (i.e., a downward stickiness in
money wages)**
This is general adjustment process – from output gaps to factor prices (specifically, wages) – is
summarized by the Phillips curve
The Phillips Curve shows how adjustment speed/pressures differ depending on the size of and
direction of the output gap

**Actually, money wage seldom fall. Real wages fall, however, if prices rise more than money
wages. We’ll use money wages for simplicity
The Phillips curve shows a negative relationship between U rate & the rate of change of ∆ in
nominal Wage rates*
Y > Y*  excess D for L  W rise quickly
Y < Y*  excess S of L  W fall slowly
Y = Y*  no excess supply/demand  Ws constant

The Phillips Curve and the Adjustment Process

*Subsequently re-drawn as a negative relationship between the rate of change in P level (i.e.,
the inflation rate) and the U rate

Emphasis:
‘Adjustment asymmetry’ and ‘downward stickiness of money wages’ means ‘adjustment
pressures differ depending on whether it’s an inflationary gap (Y>Y*) or a recessionary gap
(Y<Y*)

If Y<Y* but wages are sticky downwards, what other pressures can help the economy to adjust
to reduce the recessionary gap?
a. Expectations of recovery can raise stock prices, which increases wealth which increases
consumption
b. Replacement of ‘worn-out’ durables can raise confidence further increasing investment
and therefore employment
These may play an even larger role than falling wages in closing a recessionary gap (but well
continue to use falling wages)

Potential Output as an “anchor”

Suppose an AD or AS shock pushes Y away from Y* in the short run, creating an output gap
As a result, Ws & other factor Ps adjust until Y returns to Y*
 Y* is an “anchor” for output
When Y =Y*, the U rate is called the NAIRU – the Non-Accelerating Inflation Rate of
Unemployment (U*)
At the NAIRU
 There is no cyclical unemployment, but
 There is both structural and frictional unemployment
Let’s show this adjustment of Y to Y* in diagrams

24.3 – Demand and Supply Shocks

Positive (Expansionary) AD Shocks

Opens up Y > Y* gap, & adjustment process eventually eliminates boom & returns Y to Y*
Adjustment to a Negative (Contractionary) AD Shock
A negative AD shock opens a recessionary gap (Y < Y*)
Y falls and P falls (as the economy moves ‘back’ along the AS curve)
The U in the recession puts downward pressure on wages (& other factors Ps)
The lower production costs increase AS again. The process continues until the economy returns
to Y* and the gap is closed
But the adjustment may be slower than for an inflationary gap because of “sticky wages”

Adjustment to a Negative (contractionary) AS Shock

Example: Increase world P of raw materials imported by Canada
The economy’s adjustment process reverses the AS shift and eventually returns the economy to
its starting point.

So it matters how quickly wages adjust!

When Y does not equal Y*, speed of return to Y* depends on W flexibility

Flexible wages  quick adjustment process back toward Y*
Wages slow to adjust  sluggish adjustment back toward Y*

And downward rigidity of W can makes other forces more powerful than W in getting out of a
recessionary gap.
Repeat: Don’t necessarily need fall in money W. If % increase P > % increase W, then still have
real wages

Long-Run Equilibrium
The economy is in a state of long-run equilibrium when factor prices are no longer adjusting to
output gaps:
Y = Y*
The AS is a vertical line at Y* -- sometimes called:
 The long-run aggregate supply curve, or
 The classical aggregate supply curve
In the long run there is no relationship between the price level and potential output

Changes in Long-Run Equilibrium

In LR
 Y* determines Y, and
 AD determines only P
LR growth in Y* can come from:
 Growth in amount of factors of production
  Improved productivity via technological change
With no change in AD curve, LR growth in Y* reduces P level

The Canadian Wage-Adjustment Process: Empirical Evidence

Canadian data confirm that positive output gaps tend to drive wages and costs upward.

Part B: Fiscal Stabilization Policy

24.4 – Fiscal Stabilization Policy

The motivation for fiscal stabilization policy is to reduce the volatility of aggregate outcomes.
When an AD or AS shock pushes Y away from Y* the alternative are:
 Use fiscal stabilization policy (via ∆s in budget deficit/surplus)
  Not use – wait for the recovery of private sector demand - a shift in the AD curve
 Not use – wait for the economy’s S-side adjustment process - a shift in the AS curve

The Basic Theory of Fiscal Stabilization

The Closing of a Recessionary Gap

A recessionary gap may be closed by a (possibly slow) rightward shift in the AS curve or by a
rightward shift in AD.

The Closing of an Inflationary Gap

An inflationary gap may be removed by a leftward shift of AS (slow?) or by a leftward shift in AD

The Paradox of Thrift & Recessions

To get economy out of recession in SR, better for spending to increase, so for saving fall
But individuals prefer to reduce desired spending, so increase desired saving.
So have paradox in SR
 For individuals, desirable to increase saving
 For the economy, desirable, to reduce saving
So what’s good for individual, not good for economy as a whole

The Paradox of Thrift

In the long run (i.e. at Y*), no such paradox
Not dealing with effects on saving of recessions caused by shifts in AD – a negative relationship
between S & GDP
In LR, a positive relationship between S & GDP – GDP determined by Y* (regardless of AD).
More saving gives more investment, increasing Y*.
So what is desired by individuals is also good for the economy as a whole – no paradox

Automatic vs Discretionary Fiscal Policy

Automatic fiscal stabilization occurs through the design of the tax and transfer system:
 As Y changes, transfers and taxes ‘automatically’ change budget deficit or surplus
 Lower tax rate increases the size of simple multiplier – 1/(1-(b(1-t)-m))
 Both these work to dampen output response to shocks
Example: Increase AD and Automatic Stabilizers
AD shifts right and increases real GDP
 Government tax revenues increase, and
 Government transfers fall (fewer low-income households and unemployed persons),
giving
 Increase in net tax returns, which
 Dampens the increase in real GDP caused by the initial shock
The tax-and-transfer system reduces the value of the multiplier and acts as an automatic
stabilizer for the economy

Discretionary fiscal stabilization policy:

 Government actively changes G and/or T to change real GDP
 General agreement that automatic stabilizers work well, BUT
 Concerns about discretionary fiscal policy

Practical Limitations as Discretionary Fiscal Policy

Limitations come from:
 Long and uncertain (decision & execution) lags – so longer time it takes for full multiplier
effect
 Different impact of policy changes depending if temporary or permanent – example:
households increase spending less if think tax cuts temporary rather than permanent
 The difficulties of “fine tuning” (so ‘overshooting’)
 May be good for “gross tuning” of big output gaps
Fiscal Policy and Growth
Fiscal Stabilization policy in SR will generally have effect on LR econ growth – trade-off between
SR & LR
Case 1: for example, if start at Y*:
 An increase in G temporarily increases real GDP
 But in long term, return from Y > Y* back to Y*
 But at Y* the higher G has ‘crowded out’ some private spending
 So, investment (& private sector asset formation, I + NX) is lower even back at ‘old’ Y*
 This may reduce the future rate of growth of potential output (Y*)

Question: is there any type of increase G that can increase Y*?

Yes – spending on durable goods that would not have been made by private sector. Obvious
example is infrastructure

Case 2: what if started at Y* and government reduced t (& T) instead of increasing G?

 Stimulus in short run, shifting AD & increasing GDP. [But who gets the cuts, & how big
the SR stimulus?]
 In long run, more incentives for work effort (shifting AS) & for investment (further
shifting AD)
 The resulting increase in available resources – labour supply and capital stock –
increases Y*

Summary: Fiscal stabilization policy will generally have consequences for economic growth
1. An increase in G:
- Increases Y in the short run
- In the long run the rate of growth if Y* may be influence by effect of increase on G
private sector investment:
o Lower if private investment is lower in the new long-run equilibrium
o Higher if G increases the productivity of private-sector production (e.g., via
infrastructure)
2. A reduction in t:
- Demand stimulus in SR
- If LR growth is increased, no obvious trade-off between SR & LR – e.g., cut in corporate
tax rates can be SR & LR stimulus (if causes big rise in I hence in Y*)
- And, S-siders argue get even higher tax revenues from combination of the lower t and
higher Y* (e.g., Thatcher, George W. Bush)

Final Note
 In theory, seems no obvious trade-off between SR & LR effects of cutting tax rates –
seem OK for SR & LR
 But in practice would this be an illusion if LR effect of lower t included a fall in revenues,
causing:
 o Lower productivity in private sector by less government spending on R&D &
infrastructure?
o On other goods/services of social value (R&D, health care, national parks etc.)
that either:
 Can’t be counted for National Accounts (GDP) or
 Counted only at cost rather than societal value?

Chapter 25: Long-Run Economic Growth

25.1 – The Nature of Economic Growth

Sustained increases in Y* are a powerful method of raising living standards

Even small difference in annual growth rates can result in significant changes in living standards
after many years
Note: difference between GDP, GDP/worker, per capita GDP & relevance for Standard of Living

The Cumulative Effect of Economic Growth

Three Aspects of Economic Growth
Here you see the actual impact of economic growth.
Note: real GDP/capita grown more than real GDP/worker because greater proportion of
population is working.

Benefits of Economic Growth

 Rising average living standards
- Note: spin-off (& an unmeasured benefit): higher living standards help people feel they
can ‘afford’ to be concerned about environmental protection
 Alleviation of Poverty
- Many do not share directly in the growth
- But redistribution is easier in a growing economy – get no decrease in purchasing power
(only smaller increase)

 Recent years – biggest growth in income in many developed countries been going to top
part of the income distribution
 Rising average income has come with rising income inequality
Policy issue: What to do about it? How to do it?

Costs of Economic Growth

1. Sacrifice of Current Consumption
- If via more S to finance more I, have
- Less current consumption
o The opportunity cost of growth is less current consumption – a trade-off
o But, can mean higher standards of living in the Long Run (LR)
 A trade-off between now & the future
2. Social Costs of Growth
 Displacement fo come firms and workers
 Real transition costs caused by new products & new production techniques – some can
be hurt
Example: transition from people-operated production lines to computer-operated production
lines. Some skills that were the base for some people’s Standard of Living become redundant
Issue: how much is the reduction in natural resources a “cost” of economic growth?
Back to microeconomics for a quick answer:

The “quick and dirty: explanation: falling supply of natural resources cause their prices to rise,
which gives incentives for two things:
 More exploration to find more of the same resource
 The development of new substitute resources
Note: Texts says it’s not the same question as for Global Warming – see later in “are there limits
to growth?”

Sources of Economic Growth

The four fundamental sources of economic growth are:
1. Growth in the labour force (via Population or LFPR)
2. Growth in human capital (formal education or OJT)
3. Growth in physical capital (quantity & quality)
4. Technological improvement (new products, new production techniques, new forms of
business organization, etc.)
Different theories emphasize different sources of growth

25.2 – Economic Growth: Basic Relation

Focus on the Long Run

We focus on the long run when real GDP is equal to potential output, Y*
Let the interest rate be determined endogenously by desired saving and desired investment (at
Y*)
For simplicity we are assuming a closed economy – no trade in goods & services, so NX = 0

Investment, Saving, and Growth

First look at the ‘simple economy’ – i.e., a ‘closed’ economy with no government. In
equilibrium:
(AE =) Y = C+I, Y-C = I, so S = I
Investment (which increases capital stock) increases the future level of Y*
Investment negatively related to the (real) rate of interest
Investment (in simple model) financed by saving domestic households (and firms). Saving is
positively related to the (real) interest rate
 Interest rate is the “price” that equilibrates this market
So have negative relationship to r of I on one side of the market & positive relationship on other
– demand & supply

Now add in government

National saving = private sector saving + public sector saving
 NS = S + (T-G) = (Y* - T-C) + (T-G)
  NS = Y* - C – G
G (net of transfers) is autonomous (& unrelated to r)
Current C is negatively related to r (via opportunity cost), so is positively related to interest rate,
so NS is positively related to the interest rate
Equilibrium: Desired NS = Desired National Asset Formation
 Y* - C – G = I

The Long-Run Connection Between Saving and Investment

With Y = Y*, the condition that desired national saving equals desired investment determines
the equilibrium interest rate.
At point E, the market for loanable funds clears the equilibrium real interest rate is i*.
Note: interest rate is the ‘price’ of loanable funds

Increase in the Supply of Saving

Suppose the supply of NS increases:
 The NS curve shifts to the right
 Increases NS reduces real I rate, encouraging more I.
 Greater flow of I leads to a higher growth rate of Y*

Increases in the Demand of Investment

Now suppose that investment demand increases:
 The I curve shifts to the right
 Increases investment demand pushes up I & encourages more S by households
  Greater flow of saving (and investment) leads to a higher growth rate of Y*

Cross-Country Investment and Growth Rates, 1950-2009

The figure shows a positive relationship between investment rates and growth rates, as
predicted by our model

Neoclassical Growth Theory

This theory begins with the idea of an aggregate production function:
GDP = FT(L,K,H)
 L is the total amount of labour
 K is the stock of physical capital
 H is the quality of human capital
 T is the state of technology
The notation FT reflects the assumption that changes in technology will change the production
function

Now simplify by using only 2 factors of production, K & L

Key assumptions about the aggregate production function are:
1. Diminishing marginal product of both K and L individually – i.e., when either factor is
changed in isolation
2. Constant returns to scale for all factors jointly – when both K and L are changed in equal
proportions

Central predictions for this model?

1. From dimin MP individually:
Via law of diminishing returns, the MP of L eventually falls as each successive unit of L is used
(for fixed amount of other factors)
 So, increases in population lead to increases in GDP but eventually to reductions in per
capita GDP
 So, falling average living standards
Similarly, diminishing MP of K means that K accumulation on its own brings smaller and smaller
increases in real per capita GDP
Diminishing MP of K means that K accumulation on its own brings progressively smaller
increases in real per capita GDP
So, whether it be through diminishing MP of L or of K, standard of living eventually falls (or
stops rising)
Note: if the supply of labour increases because labour force participation rates (LFPR) increases,
a higher % of the population is producing & can get higher per capita GDP
But there must ultimately be a limit to LFPR

2. Implications of Constant Returns to Scale Jointly

If K and L grow at the same rate (i.e., ‘balanced growth’, then
 % increase in output = % increase in population (& same LFPR), so
 Will be no improvements in material living standards
o GDP will grow but per capita GDP will be constant
Now return to GDP = FT(L,K)
Neoclassical growth model creates quite ‘dismal’ prospects for achieving higher standards of
living from rising factor inputs (whether individually of jointly) sustained growth in living
standards

What’s left? Neoclassical growth model requires technological change for sustained growth in
living standards
Note: Technological change is not directly observable, so its impact is difficult to measure. This
becomes even more apparent when recognize it can arise in different ways.

Technological change can be of two types:

Disembodied: Not contained within new capital but comes from newly generated sources. For
example:
 New materials
 New products
 New production processes
 New managerial techniques
Embodied: Contained within the new capital equipment etc. (higher quality and more
productive)
Even replacement investment contains embodied technological change, and disembodied can
soon become embodied
Note: technological change can also be ‘embodied’ within the work force (L) and well as K)
Investment in Human Capital – more & better skills

The information Technology (IT) ‘revolution’ likely improved both physical & human capital
productivity. For example, better
 Information flows
 Management techniques
 Quality of learning etc.
To repeat:
In Neoclassical growth theory, increases in Y* are inextricably linked to investment in new,
more productive K.

IT revolution likely improved both physical & human capital – e.g. better information flows,
management techniques, quality of learning etc.

How much of an increase in GDP results from tech change & how much from other things?
 Cannot measure this directly
 Resort to indirect measurement
How is Technological Change Measured?
 The ‘Solow residual’
Robert Solow (MIT): in his “growth accounting” he
 Estimates what part of the growth in GDP can be explained by growth in quantities of
capital stock or the labour force, and
 The ‘residual’ – the part of growth in GDP that’s not explained by changed in quantities
of inputs – is by implication, explained by technological change
Note: May see Solow Residual called rate of growth of Total Factor Productivity (TFP)

Problem with Solow Residual:

 It underestimates the true contribution of tech change
o Same quantity and quality of K & L may be producing new & better products.
This will not be reflected in changes in the quantity of output (GDP)
o Even increases in the quantity of output attributed to increases in the quantity of
K can be an overestimate
 Some is caused by the new technology incorporated within the new K – increases in the
quality of the K
 These aspects are not counted within the ‘residual’

25.3 – Newer Growth Theories

Endogenous Technological Change

 Neoclassical growth theory treats tech change as exogenous
 Newer approach treats R & D & resulting innovation as endogenous – determined
‘within’ the system
 Various reasons behind (sources of) endogeneity:
 o Profit motive
 Research & development (R & D) is costly & risky – but the potential
profits is a big incentive
o Learning-by-doing (productivity increase with use)
 Increases productivity of new innovations
 Includes feedback from ‘ downstream’ (workers & users) to ‘upstream’
(managers & designers)
o Knowledge transfer
 R & D benefits increases over time as knowledge spreads
 There’s lower extra cost of more use because the R & D has already been
done
o Market structure and innovation
 More international competition & bigger market size makes it more
profitable to be the first to innovate
o Economic shocks spur innovation
 E.g. big changes in P of one or more inputs stimulates search for
alternative inputs or more efficient use

Increasing Marginal Returns

 Each new increment of investment is more productive than the last – i.e. there’s
increasing marginal returns
o Contrasts with the neoclassical assumption of diminishing marginal returns, and
o Historical evidence show there’s not been diminishing marginal returns to
innovation
 The sources of increasing returns usually fall into one of two categories
o Market-development costs
o Increasing returns to knowledge

Market-Development Costs
The initial R & D & marketing costs are one-time ‘fixed costs’
Subsequent investment built upon the initial R & D can give increasing marginal returns in other
ways. Some examples:
 Creates benefits for other firms & industries by:
o Creating new skills that becomes available to them
o Resolving practical problems of use, so making the new investment even more
profitable
o Using the new technology creates the infrastructure for more and more efficient
use
 Creates new attitudes among consumers:
o Consumers become more receptive of new products (obvious example is
internet)
o The number of new consumers grows and grows once they see the advantages
for others using the innovation (Facebook?)
The Knowledge Element
‘New Growth Theories’ place much more emphasis on the economics of ideas
 Knowledge is a public good. Is non-diminishable and (mostly) non-excludable
 The property of non-diminishing means the marginal cost (MC) of others using the ideas
is zero
 So, knowledge need not be subject to diminishing marginal returns, as may be the case
with other capital
The current emphasis is on such knowledge-driven growth
Rate at which we are acquiring knowledge seems to be rising

25.4 – Are There Limits to Growth

Resource Exhaustion
 Current technology and resources could not support the entire world’s population at
Canada’s average standard of living
 Does this imply absolute limits to growth?
o Technology is constantly improving
o New resources are being ‘discovered’ & ‘invented’
 But while we can have expectations about what might happen in the future, we don’t
know what technological change will happen
 Must use caution as economic growth continues

Pollution & Environment Degradation

 Not a big problem when the world only had one billion people – but now it is. The next
says that:
o Cleaning up the environment does not necessarily require less economic growth
o Policies like taxes on ‘negative externalities’ (e.g. carbon output from
production) will hurt polluting producers in the short run, but this needn’t
necessarily reduce overall economic output in the longer run
o Why not?
o Pollution taxes create greater incentives to develop technology for alternative
energy sources (e.g. solar, wind, tidal etc)
o Will the world respond in time?

Conclusion
 Economic growth may help the world with many problems
 But it new must be sustainable growth – based on knowledge-driven technological
change
 And there’s the issue of ‘equity’ for developing countries especially as the world
population rises
 Has the world already passed the point of no return?
 Most environmentalists say ‘No’ – but must act now
Chapter 26: Money and Banking

Part A: What is Money?

26.1 – The Nature of Money

What is Money? (What are its functions?)

Function 1: Money is a medium of exchange
 Must be generally acceptable to perform this function
If there were no money, goods would have to be exchanged in a system of barter
Baster is very inefficient – needs double coincidence of wants

Function 2: Store of Value

 Without high inflation, money retains its value
But with hyperinflation:
 Rush to spend before value falls even more
 Rush to spend further increases inflation, until
 People not accept money – back to barter

Origins of Money
Money has evolved over time, taking various different forms:
Metallic money:
 At first, market value of the metal = face value of the coin
 Led to debasing & clipping (note milled edges), so
 Inflation as value of precious metal in coin fell
 The ‘good money’ drops out of circulation (people keep it)
o Gresham’s Law – Bad Money Drives Out Good
Paper money:
 Was initially fully backed by precious metal, convertible on demand
 Often referred to as bank notes (issued by banks)
Fractionally backed paper money:
 Goldsmiths and banks issued more notes than amount of gold in their vaults
 Was possible because only small % want to redeem their notes at the same time
 Sometimes caused loss of confidence – ‘run’ on banks
Fiat money:
 Not backed & not convertible into anything else
 Decreed by the government to be legal tender
o Note: see writing on $20 bill
Today, almost all currency is fiat money

Modern Money: Deposit Money

Only government (via central bank) creates ‘currency’, but banks & other financial institutions
create ‘deposit money’
 Bank deposits are an important part of the money supply – the vast majority of today’s
money is deposit money
 Most transactions are simply a (net) transfer of deposits between accounts
Banks create money by issuing (far) more promises to pay (deposits) than they have in cash
reserves

26.2 – The Canadian Banking System

Most banking systems have:

 A central bank
 Many commercial banks
A central bank acts as a bank to the banking system:
 Usually a government-owned institution
 And the sole money-issuing authority

Commercial Banks in Canada

A commercial bank is a privately owned, profit-seeking institution that provides a variety of
financial services
 Accept deposits, make loans, provide credit
 Other services – credit-card services, wealth management services etc.
Banks are important “financial intermediaries” and are crucial for the smooth operation of
credit markets

Reserves
Banks’ cash reserves are normally quite small because only a small fraction of depositors want
their money at any time
A bank’s reserve ratio is the fraction of its deposits liabilities that it actually holds as reserves
 Either vault cash or deposits with the central bank
A bank’s target reserve ratio is the fraction of its deposits it wishes to hold as reserves
The Canadian banking system is a fractional-reserve system
 In March 2006 commercial banks in Canada held less than 1% of their deposits in
reserves
 In March 2018 they had 2.5% of their deposits in reserves
Reserves greater than target reserves are excess reserves
 Financial institutions make money by lending out (& ‘investing’) their excess reserves,
which
 Become the basis for creating more deposit money

Part B: Creating the Money Supply

26.3 – Money Creation by the Banking System

Some Simplifying Assumptions
Suppose:
 banks invest only in loans
 There are only demand deposits
 A fixed target reserve ratio
 No cash drain from the banking system
Note: don’t bother with the balance sheet examples in text

The Creation of Deposit Money

The bank initially has a (desired & actual) reserve ratio of 20 percent = (200/1000) x 100

A new deposit of $100 raises the bank’s reserve ratio to 27 percent = (300/1100) x 100

New deposit beings a long sequence of deposit creation.

With the target reserve ratio of 20% and no cash drain, the new deposit of $100 eventually
expands deposits by $500
By then, the full amount of the new currency deposit been absorbed by banks as an increase in
desired reserves
Generic: with no cash drain & banking system’s target reserve ratio of v, final change in
deposits = change in reserves (the new deposit) divided by v

∆Deposits = (1/v)∆Reserves
In our example, with v=0.2, $500 = 1/0.2(4100) = 5($100)

See that the sum of the additions to reserves in any round is 20% of the sum of the new
deposits created that round
For all rounds together, the banking system’s expansion of deposits is 5 times the first deposit
of new currency

Excess Reserves and Cash Drains

Deposit creation does not happen automatically. It depends on the combined decisions of:
 The central bank, which determines the amount of cash in the economy
 The public, who determine what proportion of total cash will remain for use as reserves
by the commercial banks
 The commercial banks, which decide what proportion of deposits they wish to have as
reserves (the desired reserve ratio)
So far we have assumed that 100% of any change in cash ultimately becomes the change in
reserves
Now we change this assumption by allowing for a cash drain
 If households hold a fraction of their deposits in cash, the deposit-creation process is
dampened
 Assume fixed proportion, so cash drain = c∆D = change in cash held by general public
(where cis the cash deposit ratio)
o ∆Currency = ∆Reserves + cash drain
o Change in cash held by banks = ∆reserves = v∆D
o Change in cash held by the public = cash drain = c∆D
o ∆Currency = v∆D + c∆D = (c+v)∆D
o ∆D = 1/(c+v) ∆Currency, where 1/(c+v) =deposit multiplier
 The increase in the money supply is the sum of the increase in bank deposits and the
increase in the cash held by the public (i.e. excluding the reserves in the banks)
o ∆D = 1/(c+v) ∆Currency (∆Currency is the new cash injection)
o Cash drain = c∆D = c/(c+v) ∆Currency
o ∆Ms = ∆D + Cash drain = 1/(c+v) ∆Currency + c/(c+v) ∆Currency
o ∆Ms = (1+c)/(c+v) ∆Currency
o Where (1+c)/(c+v) is the “Money Multiplier”
Note: Neither the test nor the Study Guide does the money multiplier. And what the Study
Guide calls the money multiplier is actually the deposit multiplier
 ∆D = 1/(c+v) ∆Currency
o 1/(c+v) = Deposit Multiplier
o ∆Ms = (1+c)/(c+v) ∆Currency
o (1+c0/(c+v) = Money (supply) Multiplier

Conclusion: Money supply and deposit expansion per $ of change in total cash (currency) in the
economy will be greater
 The smaller the target reserve ratio of commercial banks, and
 The smaller the public’s cash drain from the banking system

Realistic measure: See table 27-2 in text, for Dec 2008:

 V approx. 1% (i.e. reserves of commercial banks were approx. 1% of their deposit
liabilities)
 C (i.e. public’s cash/deposit ratio) could be somewhere between 1% & 5% depending on
circumstances
Let’s try both and see the sensitivity
A. Let c = 5%, v = 1%
 Deposit multiplier = 1/(c+v) = 1/0.06 = 16.67
 Money multiplier = (1+c)/(c+v) = 1.05/0.06 = 17.5
B. Let c = 1%, v = 1%
 Deposit multiplier = 1/(c+v) = 1/0.02 = 50
 Money multiplier = (1+c)/(c+v) = 1.01/0.02 = 50.5
Text: “commercial banks really do create a lot of (deposit) money out of thin air!” (But
ultimately constrained by B of C)

26.4 – The Money Supply

The money supply is the total quantity of money that is in the economy at any time
In general terms: Money supply = Currency (held by public) + Deposits
Specifically, there are several definitions of “money”

Definitions of the Money Supply

The narrowest definition of money is M1:
M1 = currency + chequable deposits
A common is broader: M2
M2 = M1 + non-chequable deposits at chartered banks
(Today, very easy to convert to chequable – via ATMs, computer, telephone)
A still broader measure is M2+:
M2+ = M2 + deposits held at institutions that are not chartered banks
(Again, easily convertible)

Kinds of Deposits
The long-standing distinction between money and other highly liquid assets used to be:
 Money was a medium of exchange that did not earn interest
 Other assets earned interest but were not a medium of exchange

Today, distinction between what is and is not a medium of exchange is very blurred. Transfers
between different types of accounts can be made extremely quickly.

M2 and M2+ in Canada, February 2015 (millions of dollars)

See how little the ‘currency’ is as a proportion of M2 (4.1%)

Near Money and Money Substitutes

Near money:
 Assets that are a store of value and are readily converted into a medium of exchange
 Short-term bonds
 Term deposits (& many can be withdrawn before ‘term’ is up, or without notice, with
interest penalty)
Money substitutes:
 Things that serve as a temporary medium of exchange but are not a store of value
 Credit cards

Choosing a Measure
There is no single timeless or best definition of money
New financial assets are continually being developed that serve some of the function of money

The Role of the Bank of Canada

We have seen how commercial banks can expand reserves into deposit money
The Bank of Canada has great influence over the amount of reserves in the banking system

Chapter 27
Part A: The Demand for Money

Perspective
1. Classical view:
Dichotomy between Monetary & Real sectors of the economy:
 In real sector, resources allocated among production of various goods & services by
relative prices
 “the neutrality of money” – change in quantity of money affect only the P level (not
relative Ps), so has no effect on allocation of resources & output level
 Economy adjusts so quickly to an output gap that even SR classical AS curve vertical
at Y*, so any change in AD simple changes P level
2. Modern view:
 Agree that money is “neutral” in long run
 But not accept that is neutral in short run
Where are we going?
So far, our model has treated investment as autonomous. But
 Investment is negatively related to rate of interest, and
 Changes in D or S of money affect the rate of interest, so
 Money affects the ‘real’ sector by affecting the rate of interest, which then affects
investment, which then affects AD and output

Our next step is to understand the link between Md and i

D for Money is influenced by OPP COST of holding it
 The opp cost is the interest (or return) that people could have earned if they have
purchased an alternative asset (investment) instead of holding the money
 This means we must first understand the relationship between the interest rate and the
value of the assets other than money
For simplicity, first restrict ‘other assets’ to government bonds
These are similar to money by being practically riskless, ‘though different from money in that
they pay interest

27.1 – Understanding Bonds

For simplicity, we assume that people have two types of financial assets:
 Money (earns no interest)
 Bonds (earn interest)
First need to understand relationship between interest rate & ‘price’ of bonds

Present Value and the Interest Rate

Present value (or discounted Present value):
 The value now of one or more payments to be made or value (interest) to be receive in
the future)
  I find its usually more easily understood by starting in reverse – what will the value in
the future of an investment made today
 Start with $100 now & invest at an interest rate of 10% per annum. What is it worth a
year later? Years’ time is worth (i.e., its future value, FV):
o FV = $100 x (1+0.1) = $110
 So to get $100 in the future you need to invest $100 in the present
 That’s saying the Present Value (PV) of $110 in the future = $100 (PV = 110/(1.1) = $100
 Writing this as a generic equation which will accommodate interest rate (i) and any FV
(in one year’s time) of $X is:
o PV = $X/(1+i)
 The higher i is, the bigger (1+i) is and the smaller PV is
 That is, ceteris paribus, the PV is negatively related to interest rate
 Now suppose you leave the $110 invested for a second year
o FV2 = (1.1)(1.1)100 = (1.1)2$100 = $121
 So, what is $121 received in 2years time worth today? It’s that $100 invested today that
generates the $121:
o PV = $121/(1.1)2 = $100 = FV2/(1+i)2
 The PV of $X to be received in 3 years’ time is:
o PV = $X3/(1+i)3
 The PV of $X to be received in 4 years’ time is:
o PV = $X4/(1+i)4

Present Value and Market Price

In a competitive market for bonds
 Buyers should be prepared to pay no more than the bond’s PV
 Sellers should be prepared to accept no less than the bond’s PV
o The equilibrium market price of a bond = PV of stream of income generated by it

Interest Rates, Market Prices and Bond Yields

Two important components:
1. The PV of a bond is negatively related to the market interest rate
2. The market price for a bond should equal its PV
Coupon payment on a bond is a constant number of $/year, but the yield is that coupon
payment as % of bond’s market price. Follow the sequence:
 A rise I rate on ‘new’ bonds reduces mkt D for outstanding (i.e., previously issued)
bond’s market price. Follow the sequence:
 The fall in D for outstanding bonds reduces their market P
 This fall in market P (not ‘face value’) increases the ‘yield’ on the outstanding bonds
Example: a $5 coupon payment is a 5% yield of the bond price is $100, but 6.25% yield if the
bond price is $80
Bond prices fall to where the $ coupon payment gives the same yield as the new higher interest
rate
So see:
  Bond’s yield is inversely related to its market P, and
 Bond’s market P is inversely related to market interest rate,
This gives the third proposition/conclusion
3. Market interest rate and bond yields tend to move together

27.2 – The Demand for Money

Reasons for Holding Money (3 reasons)
 The transactions motive
o Because payments & receipts not synchronized
o Positively related to level of GDP
 The precautionary motive
o Uncertainty about payments arising in near future
o Receipts may be less synchronized than expected
o Positively related to GDP
o These two motives together create a cash drain
 The speculative motive
o ‘hedge’ against the risks of other assets
o Most people are risk averse – prefer zero-risk money to a risky asset with same
expected PV
o Greater the opp cost of holding money (r of i), more willing to take risk
o So negatively related to r of i
Influence of Expectations:
 If expect I to rise, expect P of bonds will fall – hold more money & less bonds
 Reverse if expect i to fall
Effect of P level:
 Rise in P level rises, takes more $ for same purchasing power – i.e., same real D for M
 Nominal D for M positively related to P level/inflation rate

Summary
MD = MD (i, Y, P) – (negative, positive, positive)
Reserved for D to hold bonds – Descision to hold money is a decision not to hold bonds

Graphing It
Change in r of I – along MD
Change in Y or P – shift MD
Side note: MD curve is liquidity preference function

Next Steps
1. Determining equilibrium in the monetary sector (MD = MS)
2. Understanding how changes in monetary sector of the economy are transmitted to the
real sector – the “transmission mechanism” of monetary policy

Part B: Money and Economic Activity

27.3 – Monetary Equilibrium and National Income

Monetary Equilibrium
Occurs when the quantity of money demanded equals the quantity of money supplied:
 Equilibrium interest rate
The Money Transmission Mechanism
 Connects changes in MD and/or MS with aggregate demand
Three stages:
1. ∆MD or ∆MS - ∆ in equilibrium interest rate
2. ∆I - ∆ in desired investment expenditure
3. ∆ID - ∆ in AD

Changes in the Equilibrium Interest Rate

Stage 1: Shifts in the MS or MD curves cause the equilibrium interest rate to change
The Effects of Changes in the Money Supply on Desired Investment Expenditure

Stage 2: Changes in the equilibrium interest rate lead to changes in desired investment

The Effects of Changes in the Money Supply of Aggregate Demand

Stage 3: Changes in desired investment led to a shift in the AE function, and thus a shift in the
AD curve
Recall that here we assumed closed economy.

Summary of the Monetary Transmission Mechanism

An Open-Economy Modification
In an open economy with mobile financial capital, there is an extra channel to the transmission
mechanism
As interest rates change, financial capital flows between countries putting pressure on the
exchange rate
As the exchange rate changes, net exports change, adding to the effect on aggregate demand

The Open-Economy Monetary Transmission Mechanism

An example with a rise in MS (expansionary monetary policy)
Step 1: increase Ms (with MD constant). At ‘old’ interest rate, people are holding more money
that they wish (i.e., Ms > MD)

Step 2: demand for bonds rises, pushing up the P of bonds and lowering the rate of interest

Step 3: Bond holders want to sell Canadian bonds to invest abroad at the now higher interest
rates

Note: that this selling of bonds to invest abroad prevents the P of bonds from rising as much as
they would in a closed economy – and prevents rate of interest falling as much

So the capital outflow in an ‘open’ economy actually weakens the impact of monetary policy
through the interest rate channel

But while weakening the effect on interest rates, the capital outflow also creates a new channel
for the transmission mechanism of monetary policy (Steps 4 & 5)

Step 4: the capital outflow increases the supply of Canadian money on the international
currency markets, reducing its price (i.e., its value depreciates)

Step 5: the depreciation of the Canadian money makes exports less expensive and imports
more expensive. NX rises, and this too shifts the AD curve to the right
The net effect of (i) weakening the effect on AD through the interest rate & investment channel
and (ii) creating the new channel through imports & exports is too strengthen monetary policy

The Slope of the AD Curve

In Chapter 23, there were two reasons for the negative slope of the AD curve:
1. ∆P leads to ∆wealth which changes desired consumption
2. ∆P changes relative Ps of imports & exports, so to ∆NX

We can now add third reason – the effect of interest rates

3. ∆P changes MD & interest rate, so changing investment
Example: a rise in P leads to:
 An increase in money demand (transactions demand)
 The increases MD causes higher interest rate
 Reduces desired investment

All three effects are caused by ∆P, so creating movement along AD curve, not a shift
So whether ∆I & ∆NX show as a shift of or movement along the AD curve depends on what
causes them:
 If the cause is ∆P, it’s a movement along
 For any other cause, it’s a shift

Example 1: a rise in i decreases desired investment

 If the rise in I is caused by an increase in P**, the effect is shown as a move along AD
 But if rise in I caused by a fall in MS, the effect is shown as a shift of AD
**A rise in P makes goods & services more expensive and so increases transactions D for M. The
increase in MD increases the r of i

Example 2: a fall in NX
 If the cause is a rise in the domestic P level (increasing the price of exports), the effect is
shown as a move along AD
 If the cause is a fall in MS, which
o Raises I which
 Induces a capital inflow, which
 Reduces exchange rate, which
o Reduces NX, which
 Shifts the AD curve
27.4 – The Strength of Monetary Forces

Long-Run Neutrality of Money

A shift in the AD curve will lead to different effects in the short run than in the long run
In the long run, output eventually returns to Y*
Money neutrality is the idea that changes in the money supply do not have real effects on the
economy (i.e., real GDP at Y*)

What does money neutrality look like?

 MD shifts up as P and Y adjust to new long-run equilibrium
 (real) interest rate returns to its initial level
A: “Classical Dichotomy” (‘classical’ economists of 18th & 19th centuries) between real &
monetary sides of economy says:
 Real side of economy independent of monetary side in LR
 And believed economy reacts almost instantaneously, so
 Is no ‘short run’ to be concerned about
B: Modern economists think this is too extreme:
 Real side of economy Not react instantaneously, so
o Money will affect real variables even in SR, so
 Money is not ‘neutral’ in the SR

Some economists even questions neutrality in LR, saying

 Even though economy returns to Y* after recessionary gap,
 The Y* itself may have changed because of the recession

Its what’s known as hysteresis

Dictionary definition: the delay in the production of an effect by a cause
Economics meaning: the (long run) growth rate of Y* may be affected by the short run path of
real GDP:

Example: if U in recession causes a deterioration of skills (a fall in HC) through lack of use, then
workers are less productive after recession than before it, so Y* will be lower

Been some empirical support for hysteresis in Western Europe, but the weight of evidence is
against it for Canada

Still debatable – but let’s see what happens to productivity after the long-duration
unemployment of many workers because of COVID-19

Money and Inflation

Across many countries over long periods of time, the rate of inflation and the growth rate of
the money supply are highly correlated

Short-Run Non-Neutrality of Money

The short-run effect of a change in the money supply depends on the extent of the shift of the
AD curve
Important debate in the 1950s and 1960s regarding the effectiveness of monetary policy:
 Centred around the slopes of the MD and ID curves
 Keynesians versus Monetarists
Keynesians argued that monetary policy was not very effective
 MD curve was relatively flat
 ID curve was relatively steep

Monetarists argued that monetary policy was very effective:

 MD curve was relatively steep
 ID curve was relatively flat

Much empirical support for the idea that the money demand curve is not flat:
 Changes in money supply do lead to changes in the equilibrium interest rate, so
 Monetary policy can be effective
There is much less compelling evidence regarding the slope of the investment demand curve

Practical Problem: Separating the effect of expectations from the effect of interest rates
Example: assume the central banks expects an inflationary gap to open in the near future and
uses contractionary monetary policy to increase interest rates
Then suppose that, shortly afterwards, there is a small reduction in investment. Would this
imply that the investment D curve is quite steep?

Not necessarily…
Suppose that a higher I alone would cause big fall in desired investment – i.e., a move along
quite flat investment D curve,
But at the same time the private-sector’s expectations of a ‘boom’ shifts the investment
demand curve to the right
The resulting ‘small’ reduction in investment would be the net effect of two opposing forces,
not the result of investment being quite insensitive to the rate of interest (i.e., not a steep
investment demand curve)

Chapter 28: Monetary Policy in Canada

Part A: Implementing Monetary Policy

28.1 – How the Bank of Canada Implements Monetary Policy

Money Supply Versus the Interest Rate

Any central bank must choose its target:

 Money supply
 Interest rate
Are linked – cant target independently
 Target MS, r of I predetermined
 Target r of I, MS predetermined
Which option to choose?

Reasons why Bank of Canada targets i

1. Effect of commercial banks on ∆MS. harder to estimate ∆Cash needed to get desired ∆i
2. Unexpected ∆ MD alters ∆MS needed for desired ∆i
3. Easier for public & government to understand policy direction using ∆i
(Likely bigger ‘announcement effect’ too)

The Bank of Canada Uses Overnight Interest Rate

Rate banks borrow form/lend to each other for very short periods
B of C controls overnight interest rate by:
1. Setting a target for it
2. Setting bank rate 0.25% above this target
(will lend to commercial banks at this rate)
3. Setting borrowing rate 0.25% below target
(rate B of C pays commercial banks on their deposits)
 Keeps overnight rate within 0.5% band
The Money Supply is Endogenous
With change in overnight rate:
 Other (longer-term) interest rates change in response, so
 Public borrowing changes, so
 Commercial banks’ desired reserves change
o If excess reserves, buy bonds from B of C – reduce currency & M S
o If deficient reserves, sell bonds to B of C – increase currency & MS
B of C can also increase/decrease bonds held by general public
Central Bank’s buying & selling bonds called open-market operation
Used to ‘accommodate’ the ∆i by appropriate ∆MS
 ‘Appropriate’ ∆MS is what’s needed to keep I on target
 MS endogenous

Expansionary and Contractionary Monetary Policies

Explansionary: reduction in target rate
 Eventually B of C increases MS (or its growth rate)
Contractionary: increase in target rate
 Eventually decreases MS (or its growth rate)
Why growth rate?

If MD increasing by 10% per year:

*Increase MS by 11% is expansionary
*Increase MS by 9% is contractionary
Review of the Monetary Transmission Mechanism

Part B: Targeting Inflation

28.2 – Inflation Targeting

Why is Inflation the Ultimate target of Mon Pol?

1. Costly for individuals
a. Hurts people on fixed incomes
b. Hurts lenders & benefits borrowers
2. Costly for the economy
a. Impact on next exports
b. Impact on economy’s ability to send ‘signals’
Example: is an increase in a good’s P a rise in its relative P, or just part of increase in overall P
level

The Role of the Output Gap for Mon Pol

When an output gap opens, B of C has two choices
 Allow the adjustment process to operate
 Intervene with monetary policy
May intervene if expects output gap to keep inflation outside its target band for significant
length of time (Target 2% in Canada)
May not intervene if expects gap to be only short-term
Now so schematic diagram for using mon pol as Stabilization Policy (i.e., reduce the fluctuations
in GDP)
Complications in Inflation Targeting
1. Volatile Food and Energy Prices
Many Ps set in world markets – unrelated to Canadian output gaps
 B of C also uses core inflation as a short-run indicator
 Better reflects pressures of domestic output gaps
‘Core’ rate excludes food & energy prices
 Energy: influence of world markets
 Food: world + volatile
CPI is B of C’s long-run target

Canadian CPI and Core Inflation, 1992-2015

 2. Exchange Rate Complication for Monetary Policy
Use two examples of appreciation of Canadian $

Example 1: Canadian dollar appreciation caused by increase in foreign D for Canadian exports:
 Increases AD
 Creates Y>Y* (inflationary gap)
 Appropriate response is contractionary monetary policy

Example 2: Canadian dollar appreciation caused by increase in foreign D for Canadian monetary
assets (e.g., bonds)
 Reduces NX (X fall & IM rise)
 Reduces AD
 Creates Y < Y* (recessionary gap)
 Appropriate response us expansionary monetary policy
Appropriate monetary policy response to change rate change differs by cause of the change

28.3 – Long and Variable Lags

Long & variable time lags of Mon Pol mainly because:

 Takes time for I and NX to respond to ∆i
 Once I and NX change, takes time for the full change in AD (via simple multiplier)
Is mon pol destabilizing because of these lags?

Lessons From History

Two different views of role of monetary in Great Depression (1929/33)
Monetarists: the big downturn in real sector (drop in output & employment) was caused by a
big drop in MS. Drop in deposit money when some banks failed

Keynesians: Reverse it: Fall in MS a result of the downturn in the real sector. Follow the process:
  A big drop in output & employment in construction, combined with
 A stock market crash, together
 Reduced wealth, which
 Caused drop in consumption spending, causing
 Drop in demand for deposit money, causing
 Fall in MS

Is Monetary Policy Destabilizing?

Some monetarists argue it is destabilizing
Example:
 Increase MS to close a recessionary gap
 Lags allow other changes to happen before the full effect of ∆MS felt
 ‘overshooting’ creates an inflationary gap
This policy had wrong strength and/or timing

Some monetarists argue for a monetary rule

 Increase MS at a rate consistent with long-term growth of pop & prody
o Problem: what if MD unexpectedly shifts?
Most economists do agree that:
 Mon pol likely inappropriate for ‘fine-tuning’
 Appropriate for gross tuning – large & persistent shocks
Because of the lags, B of C policy must be forward-looking
 It must take pre-emptive actions, which
 May appear inconsistent with current state of the economy
Example: tighten policy in a recessionary gap because of expected future inflation

Political Difficulties?
Lags mean monetary policy must be forward-looking
 Policy may seem inconsistent with current state of economy – tightened now because of
expected future inflation

B of C target is 2% inflation – why not 0%?

Inflation helps economy’s adjustment process by its effect on real wages (w/P). Example: what
if in a recession?
 Objective is to close a recessionary gap, which may need
 reallocation of labour to other sectors (to produce more of the products in high demand
even during the recession), which
 is made more difficult by downward-sticky money Ws
Inflation can speed up the reallocation by changing real wages W/P
1. in contracting sectors of economy
 constant money W, with
 rise in P level, causes
 fall in W/P
2. in expanding sectors
 increase money W more than inflation rate, causes
 increase in W/P

So the debate continues as to what the B of C should target

1. target low inflation rate
 inflation reduces W/P in contracting sectors where money W are not rising, which
 stimulates reallocation to other productive sectors instead of having more and longer U
2. target zero inflation
  avoids negative effects on inflation, and
 leaves reallocation to the market forces of D & S, and the unemployed will eventually
accept lower money wages

28.4 – 30 Years of Canadian Monetary Policy

Chapter 29: Inflation and Disinflation

Overview: High inflation is undesirable because it
 creates arbitrary redistributions of income
 lowers standard of living of people on fixed incomes
 undermines the efficiency of the price system – reduces ability to identity the relative Ps
of goods & services

29.1 – Adding Inflation to the Model

Why the Economy’s Wages Change

Output gaps
 Y > Y* excess demand for labour (U < NAIRU)
 Y < Y* excess supply of labour (U > NAIRU)

Expectations
Some Ws raised in anticipation of inflation. So, 2 forces:
Change in Money Wages = Output-gap effect + Expectational effect

From Wages to Prices

Change in W shifts AS
Actual inflation = Output-gap inflation + Expected inflation + supply-shock inflation
Supply-shocks shift AS by factors other than W changes (e.g., productivity change, changes in
world oil prices)
These can’t be controlled by domestic policy, so ignore in our analysis
At Y = Y* (U = NAIRU), no output gap and actual inflation equals expected inflation

Assume expected 5% inflation rate

 If Y = Y* wages rise by 5% (expectations only)
 If Y > Y* wages rise > 5% (inflationary output gap’s upward pressure on actual inflation,
plus expectations of rising prices in the future)
 If Y < Y* wages rise < 5% (recessionary output gap’s downward pressure on actual
inflation, plus expectation of rising prices in the future)

Assume productivity improves by 5%

W increase of 5% -- no change in AS (fall in production costs by increased productivity is offset
rise in production costs due to higher wages. No net change in production costs)
W increase > 5% -- AS shifts vertically upwards. (fall in production costs by increased
productivity more than offset by increased wages. Net increase in production costs)
W increase < 5% -- AS shifts vertically downwards. (fall in production costs by increased
productivity only partially offset by increased wages. Net reduction in production costs)

With Constant Inflation

If expected = actual (assume 5%)
 Y must equal Y* -- no output gap
How can (e.g.) 5% inflation continue without output gap?
 AD must be constantly increasing
If the expectation of future inflation prove false, subsequent expectations of future inflation will
become weaker
To prevent this erosion of expectations, the monetary authorities must make the expected
inflation actually occur. To do this it must continually increase AD by continually increasing the
money supply
In economic terminology, the expectations must be validated by continual increases in MS

If the economy remains at Y* there’s no output gap effect on prices. The only influence on
inflation, therefore, is expectations
To ‘validate’ expectations of (say) 5% inflation the monetary authorities must increase the MS
by 5%
 If MS were increased by more than 5% an inflationary output gap would open, Y > Y*,
inflation would rise above 5%.
 If MS were increased by less than 5% a recessionary gap would open, Y > Y*, inflation
would fall below 5%.
 So, to keep Y = Y* (i.e. prevent an output gap from opening), then
o the rate of increase of MS must equal the expected inflation rate
Here we see it. Continual validation keeps AD curve moving up at the same rate as the AS curve,
no output gap opens up, and actual inflation remains equal to expected inflation.

29.2 – Shocks and Policy Responses

Demand Inflation
Demand shock (e.g., rise in NX) increases AD from AD0 to AD1
Rate of increase of W rises costs of production go up, & if AD remains at AD 1 (i.e. no validation)
the output gap is eroded until GDP back at Y*
Without further validation, inflation come to a halt
So, inflation was only temporary
But with continuing monetary validation of inflation at Y1:
 AD keeps increasing, which
 Keep inflationary gap open, which
 Keeps both pressures (output gap + expectations) on inflation, which
 Causes accelerating inflation

Why this sustained inflation accelerates?

Assume constant 5% (= expected inflation) at Y = Y*
 Then a D shock causes Y > Y*
 Adds 2% demand inflation – total 7%
o 7% becomes the expected rate
 Validation keeps Y > Y* - adds another 2% = 9%
o Expected rate becomes 9%
 Validation keeps Y > Y* - adds another 2% = 11%
o Expected rate becomes 11%
Summary:
If central bank keeps Y > Y* via continued monetary validation:
 Get progressively increasing W rates, causing
 Progressively bigger upward shifts in AS curve, needing
 Progressively greater increases in Ms to keep Y . Y*
Without monetary validation, accelerating inflation couldn’t happen

Supply-Side Inflation without Validation

Start with a negative AS shock shifting AS0 in the direction of AS1 and recessionary gap opens
If the monetary authorities don’t validate, AD stays at AD 0 and the economy eventually returns
to Y*

Initially the upward pressure on Ws from expectations exceed the downward pressure from the
recessionary output gap, so there’s both rising prices and falling output. This is called
‘stagflation’ (i.e., stagnation with inflation).
Because of these opposing forces, inflation declines. Thus the level of expected inflation falls. As
this continues, the effect of the output gap will become equal the effect of expectations and the
reduction in AS will stop (AS1 in the diagram) And inflation comes to a halt
Thereafter the effect of the output gap on prices exceeds the effect of expectation on prices, AS
shifts to the right, inflation falls, the output gap closes, and eventually the economy returns to
Y*
Conclusion: With Y < Y* & no monetary validation Y returns to Y* – but only slowly because
wage rates are downwardly ‘sticky’. Again, inflation without monetary validation is temporary

Supply-Side Inflation with Validation

As before, the economy comes to a short-run equilibrium at E1
Without validation the economy slowly returns to Y*
The return, however, can be speeded up by the monetary authority validating the initial
inflation, raising AD to AD1
Potential danger of validation: Prices rise (P1 to P2), and if this new inflation rate becomes
expected, wages will increase again, AS may not return to AS 0 and the output gap may not close
Further validation will continue the process, and the economy gets into a wage-price spiral

Summary – Inflation as a Monetary Phenomenon Causes, Consequences, Conclusions

Causes of inflation
 Anything that increases AD will cause P to rise
 Rise in factor will decrease AS and cause P to rise
 Without continual monetary expansion, rising P must eventually halt
Consequences of inflation
 Demand inflation tends to raise Y above Y*
 Supply inflation tends to reduce Y below Y*
Once costs and prices have fully adjusted in the long run, the shifts in either AD or AS will have
 Affected prices/inflation, but
 Left output unchanged at Y*

Conclusions about monetary policy and inflation:

 Without monetary validation, positive AD shocks or negative AS shocks
o Cause temporary inflation, and
o Output eventually returns to Y*
 Inflation started by either AD or AS shocks can only be sustained with continuing
monetary validation, therefore
o Sustained inflation is always a monetary phenomenon

29.3 – Reducing Inflation

The Process of Disinflation

Reducing inflation is often costly. The economy loses output & creates unemployment in the
process
Let’s start with an inflationary gap and accelerating inflation (with continued validation) There
are tree policy phases to stopping inflation & returning to Y*
 Close the output gap (Y>Y*)
 ‘Break’ inflationary expectations (create Y < Y*)
 Recovery – Y back to Y*
Phase 1: Removing Monetary Validation
Start at E1
 Stop increasing Ms
 AD curve stops shifting
W will rise because of
 Inflationary expectations
  Out-out gap effect Y>Y*
AS still shifts up & P still rise
Higher P increases Md which, without increasing the Ms by validation, raises the i rate which
then
 Reduces I & NX, so
 Move along AD & the output gap closes

Phase 2: Stagflation
At Y* expectations are still increasing wages
Stagflation as AS keeps shifting via expectations
Recessionary gap opens – downward pressure on W via output gap effect (Y < Y*)
At E3 the 2 pressures offset each other AS stops shifting, inflation stops
Breaking inflationary expectations has been a slow process

Phase 3: Recovery
Eventually, recovery takes output to Y*, and P is stabilized. Two ways for this to happen.
Either wait for wages fall, bringing the AS curve back to AS 2…
… or the central bank increases the money supply sufficiently to shift the AD curve to AD 2
It’s a trade-off: (i) faster return to Y*, but (ii) possibility of creating new inflationary
expectations

The Cost of Disinflation: The Sacrifice Ratio

The cumulative loss in real GDP (as % of Y*) divided by the reduction in the rate of inflation (%),
is called the sacrifice ratio
Suppose the cumulative loss is 10% of Y*. Since inflation fell by 4 percentage points, the
sacrifice ratio is 10/4 = 2.5

Chapter 30: Unemployment Fluctuations and the NAIRU

Reminders from Chapter 19

Employment, Unemployment, and the Labour Force

Employment (E): the number of workers (15+) who hold jobs
Unemployment (U): the number (15+) not employed but actively looking for a job
Labour force (LF): E + U
Unemployment rate: U as a % of LF – U/(E+U)*100

Unemployment rate = (Number of people unemployed/Number of people in the labour force)

x100
Note: The number of Ued can increase even if U rate is unchanged
Even when Y = Y*, some unemployment exists:
 Frictional unemployment (natural turnover)
 Structural unemployment (mismatch between jobs and workers)
When Y < Y*, there is also cyclical unemployment – a result of the economy’s output gaps over
the business cycle

Productivity
Productivity: output per unit of input
The productivity of labour is the relevant one here
 Usually measured as (real) GDP per worker
 Or (real) GDP per hour of work
The latter is a more accurate definition of labour productivity, but harder to collect data which
to measure it

Increases in productivity is probably the single largest cause of LR increases in the average
Standard of Living*
The major causes of increased productivity are
 New and better technology
 Improvement in skills (education among them)
*Note: A 3% increase in real GDP with a 4% increase in population gives reduction in the
average S of L

30.1 – Employment and Unemployment

(just the following points)
Changes in Unemployment & Employment
The short run:
Over the business cycle
 E (employment) and U (unemployment) fluctuate
 LF (labour force = E + U) is relatively stable
The long run:
U rate stable because % ∆E approx. = % ∆LF

Flows in the Labour Market

Stock of U (U rate) at point in time (U rate) underestimates flow in & out of the labour force
over time
Example: 2016-2017
 Canadian U rate was approximately constant at about 6% but
 There were big flaws into and out of Y:
o 500 000 to 600 000 jobs created per month
o Number of people leaving labour force approx. = numbers entering, so LF
approx. constant
Thus many more people experience unemployment over the year than are unemployed at any
point in time during the year

Reminder: U* is U rate at Y*, which is the Non-Accelerating Inflation Rate of Unemployment –

NAIRU

Problems in Measuring Unemployment

In Canada (& U.S. & UK and many more) people are classed as ‘unemployed’ if they (i) are not
working, and (ii) are searching for work.
Measuring U rate can understate impact of recessions on unemployment because:
  Long-term Ued can become ‘discouraged workers’; stop looking for E and leave the
labour force (at least until the economy improves)
 In recessions there can be many part-time workers who want full-time jobs – they are
‘underemployed’

30.2 – Unemployment Fluctuation

A: Market-Clearing Theories
Economy adjust so rapidly that output gaps don’t exist
So GDP always = Y*, and U rate always = U*
And at Y* there is no cyclical unemployment – all U* is frictional or structural

Characteristics of the labour market in market clearing theories:

 Wages flexible (not ‘sticky’) downwards in recessions (so even a small output gap opens,
it closes almost immediately
 E can fluctuate but no cyclical fluctuations in U (see the next diagram)
 All U is voluntary
If D for L falls
o Some workers choose to take lower W & stay employed
o Others choose to leave the labour force rather than accept a lower wage

Labour Market Clears: Employment fluctuates

The labour market is always in equilibrium (Qd = Qs). Thus, there is never any excess supply of
labour – i.e., nobody who wants to work isn’t working. So, no unemployment

Problems with market-clearing theories:

Inconsistent with facts (in developed countries):
 Real wages do not fall much in recessions (so labour markets don’t clear quickly)
  Most workers who lose their job do not withdraw from LF – they stay in the LF and
search for work
 Unemployed workers do want a job – their unemployment in involuntary (not
voluntary)

B: Non-Market-Clearing Theories
Like market-clearing theories, in the long run U=U* (the NAIRU) since Y=Y*
Unlike the market-clearing theories, the non-clearing theories recognize that there are output
gaps in the short run. So, in the short run:
 The economy can be where Y does not equal Y*, and U does not equal U*
 Ws do not adjust quickly (i.e., are ‘sticky’)
 There is a cyclical and involuntary U

Recessions:
Excess S of Labour (U > U*)
Cyclical U of (L’1-L1)
Ws ‘sticky’ downwards, so the labour market does not clear quickly. (L’-L 1) persists

Booms:
Ws increase flexible
Excess D for L (U < (or equal) U* of (L’2 – L2)
Ws flexible upwards, so market clears quicker than in recession

Why are wages “sticky”?

1. Long term relationships between workers & employers
One cause is quasi-fixed hiring & training costs incurred by the employer
Firm’s quasi-fixed costs of labour incurred only once per worker – fluctuate with number of
workers hired, not by hours per worker
Employer has incentive to keep the worker long in order to
 Recover the quasi-fixed costs spent on that worker, rather than
 Lay off a worker in recession but then pay quasi-fixed costs again when hires & trains
a replacement worker as economy improves
 Avoid losing the extra productivity of the worker once trained
2. Menu Costs
Usually, firm incurs administrative costs when changing product P & wage rates.
Especially if fall in output expected to be temporary, employer may avoid these costs by not
changing W rates.
Respond to changes in demand more by changing output & employment rather than prices and
wages.
3. Efficiency Wages
Employer pays W > market-clearing (i.e., equilibrium) W. Why?
 It attracts higher-quality (more productive) workers
 Creates incentive for workers to maintain higher productivity once employed (worker
sacrifices the higher W if leaves – i.e., a higher opportunity cost of leaving)
 Firm wants to keep these high-productivity workers during a (temporary) downturn in
the economy
o Doesn’t want to risk the possibility of losing them when product demand rises
again
4. Union Bargaining
When demand falls, unions usually prefer to have workers laid off rather than reduce wages
When demand rises again, employer wants to rehire the workers, & no need to union to
bargain again to raise back to previous level

Results:
 Union wages are ‘sticky’
 U of union members in recessions is higher than it would have been with flexible wages

5. Government Policies
Do they affect labour market flexibility?
Use EI (Employment insurance) as an example
Do the EI benefits increase workers’ time between jobs?
 Benefits reduce the opportunity cost of staying unemployed for longer. How does the
unemployed worker react?
 Do benefits harm market-clearing by reducing regional mobility? They reduce
unemployed workers’ (financial) incentive to move to where firms are hiring. Do they
respond to that incentive?
But also, social and economic benefits:
 Do they promote longer search time, raising efficiency by creating a better match
between skills for jobs & skills for workers?
  Social benefits created by redistributing income to reduce hard ship

Chapter 31: Government Debt and Deficits

31.1 – Facts and Definitions

The Government’s Budget Constraint

Government expenditure must be financed by taxes or by borrowing:
Government Expenditure = Tax Revenue + Borrowing

Government expenditures are composed of:

 Purchases of goods and services = G
 Debt-service payments = I x D
 Transfers
Budget constraint is:
G + I x D = T + Borrowing
(G + I x D) – T = Borrowing
Recall T is net tax revenues after transfers
The government’s annual budget deficit funded by:
 Annual flow of borrowing, which
 Is the change in the stock of National Debt
Budget Deficit = ∆D = (G + I x D) – T
If there is a:
 Budget deficit (positive value) – the debt (D) rises
 Budget surplus (negative value) – the debt (D) falls
The primary budget deficit:
 Deficit on the non-interest part of the budget:
Primary budget deficit = total budget deficit – debt-service payments = (G + I x D – T) – I x D = G
–T
G – T shows how much of current program (i.e., non-interest) spending can be paid by current
tax revenues

Deficits and Debt in Canada

31.2 – Two Analytical Issues

Issue 1: The Stance of Fiscal Policy

Change in budget deficit can be caused by
 Changes in economic activity (GDP)
 Changes in government fiscal policy to influence GDP
‘Stance’ is basic direction of fiscal policy: expansionary, contractionary, neutral

The Budget Deficit Function

Budget Deficit = (G + I x D) – T
If GDP = $0,
Deficit = total government spending = G + I x D
As GDP rises, so does T:
 T = tY
So, deficit falls:
 Deficit negatively related to GDP

Fiscal Policy sets position & slope of budget deficit function

 G & D & i affect the position
 T affects the slope
Change in real GDP moves along the budget deficit function

Structural and Cyclical Budget Deficits

Structural component: (i.e. cyclically adjusted deficit)
Whatever the actual Y, the deficit that would exist at Y*
(with current fiscal policies) = structural budget deficit

Cyclical Component
Difference between the actual deficit & the structural deficit
 (Y < Y*), actual deficit > structural deficit
 (Y > Y*), actual deficit < structural deficit
  NB: if Y* were at Y**, have negative structural deficit – i.e. a surplus = S

Change in total deficit can be caused by:

 change structural deficit (i.e. change in fiscal policy)
 change in cyclical deficit (i.e. GDP changes but fiscal policies unchanged.)
Change in structural deficit reflects change in stance of fiscal policy
Expansionary: policy change increases the structural deficit
Contractionary: policy change reduces the structural deficit
Expansionary fiscal policy shifts up budget deficit function
 Structural deficit rises
 Actual deficit rises (at a given Y)

Issue 2: Debt Dynamics

∆d = x + (r – g) x d
∆d = ∆[D/GDP] = change in D/GDP ratio
X = (G – T)/GDP = the rise in D/GDP caused by primary budget deficit
r x d = (r x D)/GDP = the rise in D/GDP ratio caused by debt service payments
g x d = D/(g x GDP) = fall in D/GDP ratio caused by rate of growth of GDP

∆d = x + (r – g) x d
Three cases:
Case 1: r = g
(r – g) x d = Zero
So any change in D/GDP ratio (∆d) must be caused by x i.e. by (G-T)/GDP
 Primary deficit (G.T) increases D/GDP ratio
 Primary surplus (G<T) reduces D/GDP ratio
 Balanced primary budget (G=T), no change

∆d = x + (r – g) x d
Case 2: r > g
(r – g) x d > 0, which by itself would increase the D/GDP ratio
But it isn’t ‘by itself’ – there’s also X
1) If X is positive (i.e. primary deficit) it would also increase D/GDP, so combining the two
means D/GDP must rise
 2) 2) If X is negative (i.e. primary surplus) it’s pushing D/GDP in the opposite direction, so
there are two opposing forces on D/GDP
a. D/GDP will fall if the primary surplus is big enough to dominate effects of the
debt service payments
b. D/GDP will rise if it isn’t

∆d = x + (r – g) x d
Case 3: r < g
(r – g) x d < 0
1) If X is negative (primary surplus) D/GDP must fall
2) If X is positive (primary deficit) then D/GDP ratio
a. Will fall if primary deficit not big enough to offset effects of the debt service
payments
b. Will rise primary deficit is large enough

Two lessons about the overall budget deficit/surplus:

When GDP is growing:
1. D/GDP ratio fall if budget is not is deficit
a. i.e. is in balance or in surplus
2. a budget deficit may or may not reduce D/GDP ratio
a. i.e. it depends on size of primary deficit (x) compared to the rate component (r –
g) x d

31.3 – The Effects of Government Debt and Deficits

National saving = public saving + private saving

National saving = government budget surplus + private saving
We’ll assume that changes in government saving are not offset by changes in private saving, so:
 changes in the budget surplus/deficit change National Saving
Why is it an assumption?
 Deficit is deferred taxes, so
 Current taxpayers may increase their savings now in anticipation of higher taxes in
future
 Total offset called “Ricardian Equivalence”

Do Deficits Crowd Out Private Activity?

Crowding out: expansionary fiscal policy reduces private spending. How?
Government sells more bonds to finance the deficit, which
 Increases the supply of bonds, which reduces P of bonds, which increases the interest
rate, which reduces private investment, AND
 Causes capital inflow, which appreciates the currency, which
 Reduces net exports

If the economy returned to same Y*, crowding out:

G = (I + NX)
But will it necessarily be the same Y*?
What if that budget deficit includes a rise in G which is spent on projects that help increase
future Y*, (e.g. infrastructure, R & D, health?)
Has potential to ‘crowd in’ private-sector activity over long run
Conclusion:
In the long run, the net difference between ‘crowding out’ & ‘crowding in’ depends on
 How much Y* ruses which in turn depends on what was the extra G spent?
The ‘crowding out’ of private-sector investment by itself could reduce future economic growth
But what if the increase G was also investment? Government spending on improving
infrastructure, for example, this could facilitate future private-sector investment and actually
help to increase Y*
So, do deficits ‘crowd out’ private activity? It depends on what the government spends the
deficits on

Do Deficits Harm Future Generations?

Debt redistributes resources & consumption
 Away from future generations and
 Toward the current generations
Burden on future generations depends on type of G spending that’s financed by the budget
deficit
If finances public investment (infrastructure, medical research)
 May have no net burden for future generations, since
o Although they pay for it (via more debt)
 They also get the benefits
Problem: many government expenditures can be hard to classify as ‘consumption’ or
‘investment’

Does Government Debt Make Economic Policy More Difficult?

1. Monetary policy
A high D/GDP with littles prospect of future surpluses may cause:
 Expectations that central bank will monetize the debt by purchasing bonds to finance it.
[In effect, expectation of expansionary monetary policy]
Expectation of monetization (even if not happen) can cause expectation of inflation, which
 Fuels actual inflation, and
 Makes monetary policy more difficult

2. Fiscal Policy:
Very high D/GDP ratio may severely restrict ability to use counter-cyclical fiscal policy
 Debt service payments are high % of tax revenue, which
o May restrict ability to use fiscal policy, since
 Less ‘room’ for debt-financed
So may be unable to have stabilizing fiscal policy (especially in recessions when need/want
deficit)

31.4 – Formal Fiscal Rules?

Can formal fiscal rules prevent excessive build-up of debt

1. Annually Balanced Budgets?
Force discipline on governments
- But leads to pro-cyclical fiscal policy
- In recessions, must raise tax rates & reduce G spending balance the budget in recessions
- Opposite to what needed in recession
Reverse in boom – again opposite to what needed
Result: would accentuate the business cycle

2. Cyclically Balanced Budgets?

Balance budget over the business cycle:
- Surplus in booms ‘pay for’ the deficits in recessions
- Good in principle, but very difficult to define and implement
- Can we accurately predict course of business cycle?
And expect political problems
- Raise tax rates just before an election?
- Have discipline not to increase G when T revenues high in a boom?

3. Keep a Prudent D/GDP ratio: allowing for growth

Formal fiscal rules emphasize the budget deficit, but
- D/GDP ratio probably more important than deficits

∆d = x + (r – g) x d
G = % increase in GDP, which alone reduces D/GDP
Can have budget deficit with no rise in D/GDP
- With r < g, can have deficit and falling D/GDP

Chapter 34: Exchange Rates and the Balance of Payments

34.2 – The Foreign-Exchange Market

34.3 – The Determination of Exchange Rates

Flexible exchange rate:

Determined by D & S with no intervention by central bank
Fixed exchange rate:
To keep it stable needs intervention by central bank

Flexible Exchange Rates

Demand and supply determine price. Here it’s the Canadian $ price of the euro (€)
Exchange rate adjusts to clear the foreign-exchange market

Changes in a Flexible Exchange Rate: (Standard D & S)

Canadian $ (C$) depreciates (X-rate rises) when
  There’s an increase in the C$ demand for the foreign currency, or
 A decrease in foreign currency for C$ (i.e., decrease S for foreign currency)

Fixed Exchange Rates

At rate fixed above e0 C$ is ‘undervalued’ relative to market equilibrium. To keep the C$ from
appreciating (i.e. X-rate falling), Bank of Canada must ‘absorb’ the excess supply of € by selling
$C & buying €
At rate fixed below eo C$ is ‘overvalued’ relative to market equilibrium. To keep the C$ from
depreciating (i.e. X-rate rising), Bank of Canada must ‘absorb’ the excess D for C$ by selling €
(from its foreign currency reserves) to buy $C
34.2 – Three Policy Issues

Is a current account deficit “bad” and a surplus “good”?

(Current account deficit is when value of our imports in goods & services (G & S) exceeds the
value of our exports of G & S. Current account surplus is the reverse)

First develop an alternative way of specifying the current account surplus (CA). We’ll do it using
injections & withdrawals
At equilibrium, injections = withdrawals: G + I + X = S + T + M

Rearrange: (X – M) = S + (T – G) – I
(X – M) = NX + CA surplus
CA + S + (T – G) – I (Note S + (T – G) is National Savings

Case 1: CA = 0 (current account in balance)

0 = S + (T – G) – I so S + (T – G) = I
Thus, CA is in balance (X = M) when
 Domestic investment is fully financed by national savings

Case 2: CA < 0 (current account in deficit) S + (T – G) < I

 Investment is only partly financed by domestic savings
 Rest must be financed by foreigners
Is this ‘bad’? Not necessarily – it depends on the cause
CA deficit can be ‘good thing’ if caused by a strong economy
What if strong economy creates:
 Optimistic expectations, which
 Attracts foreign capital, which
 Finances more investment, which
 Further contributes to strong growth
‘Good’ for the economy

Case 3: CA > 0 (current account in surplus) S + (T – G) > I

 Domestic saving exceeds investment
 We use our excess savings to buy foreign assets
Is this ‘good’? Not necessarily – it depends on the cause
CA surplus can be a ‘bad thing’ if caused by a weak economy
What if a weak economy creates pessimistic expectation? In response:
 Households increase S (decrease C) & firms decrease I, together increasing (S – I)
 Decreasing GDP causes decrease T, which reduces (T – G)
o Recall: CA = (S – I) + (T – G)
o So if increase (S – I) > decrease (T – G), then increase CA
o In this case CA surplus caused by weak economy is ‘bad’
Is there a “correct” value for the Canadian Dollar?
Can’t say C$ ‘overvalued’ or ‘undervalued’ at the free-market equilibrium without asking
“relative to what?”

Purchasing Power Parity (PPP) Theory

This theory says: the ‘correct’ exchange rate equalizes the cost of the same bundle of goods in
all currencies
So for the same bundle of goods, the exchange rate € should make it’s cost (i.e. price) in
Canadian dollars (PC) equal to its cost in euros (Pe)
That is, Pc = e x Pe
Rearrange: ePPP = Pc/Pe
So in PPP theory, the correct’ value is where exchange rate = relative prices

If PPP worked, the actual e and the ePPP would move closely together

Two reasons why e and ePPP don’t move closely together?

1. There are many non-traded goods, so the exchange rate doesn’t put any pressure on
these Ps to move PC/PE to PPP levels
2. Different countries don’t produce or consume the same basket of goods even for the
same products, different countries consume them in different proportions, so having
different ‘weights’ in their Consumer Price Index

When will a currency be neither ‘overvalued’ nor ‘undervalued’?

The “right” value is generated by D & S in the foreign exchange market when there is neither
excess demand nor excess supply of the currency
There is no “right” value as the D & S equilibrium can continually adjust in response to a variety
of ‘shocks’ (as seen in earlier chapters)

Should Canada have a fixed or a flexible exchange rate?

Advocates of a fixed exchange rate argue that it would stimulate trade (hence the gains from
trade) by removing the uncertainty faced by Canada’s exporters and importers. They also argue
it would reduce the administrative costs of international trade.

Advocates of a flexible exchange rate argue that, compared to a fixed rate, it gives flexibility to
the economy and reduces the impact of negative ‘shocks’ on the economy. The emphasize the
“Shock Absorber” effect of a flexible exchange rate.

“Shock Absorber” Effect

Take an external ‘shock’ to the economy via a fall in foreign D for our exports. The impact of
this negative ‘shock’ on GDP and unemployment will be dampened by a flexible exchange rate

The fall in D exports also reduces the demand for C$ on foreign exchange markets. With a
flexible rate the C$ depreciates, which lowers the foreign price of our exports and increases the
domestic price of imports

The resulting effect on net exports reduces the negative effects of the initial fall in D exports, so
GDP & employment do not fall as much as they would under a fixed exchange rate.

A fixed rate would have prevented the description of the $C thereby eliminating the ‘shock-
absorber’ effect on GDP & employment

Absorbing ‘Shock’ of Fall in Demand for Exports

Decrease D for X gives decrease S of €
With a fixed exchange rate:
 Exchange rate stays at e0
 AD0 shifts falls to AD1
With a flexible exchange rate:
 Exchange rate rises to e1
 The fall in NX is reduced
 The AD0shifts falls to AD2
AD2 < AD1
Y2 > Y1